Protecting the farmer is protecting the food security

We are not too late to bring this time-tested system home to protect both the farmer and the food security

Establishing a local futures exchange would mitigate problems of paddy farmers and political problems propelling out of falling market prices of paddy during harvesting time. Such a futures market could be used for all agricultural products not only to stabilise the prices but also to provide greater liquidity for the producer

Farmers face two main types of risks: production risk and price risk. The risk of production, or risk of return, concerns events of chance origin, related to the nature, to which the producers are exposed. These shocks are linked to either rainfall and climatic variations, invasions of insects, or the occurrence of diseases. Price risk due to price volatility refers to unexpected price fluctuations that are so large and rapid that it becomes impossible to meet expectations. 

In agriculture, prices are subject to strong fluctuations. The significance of this price risk is mainly due to the lag between the production decision and the timing of the harvest associated with the low price elasticity of demand. Price instability in Sri Lanka increased as a result of the liberalisation of the local economy in 1977 which the agricultural sector was quite sensitive to. While farmers in developed countries have access to market-based tools to hedge against price risks such as insurance or futures markets these tools are generally unavailable or very weakly developed in developing countries like Sri Lanka. The effort of this article is to enlighten the public and authorities on the possibility of establishing paddy and other agricultural product futures trading which is a dynamic market-based solution to mitigate the risk of unsustainable fluctuations in prices especially during the harvesting season. Protecting the farmer is protecting the food security.

Establishing a local futures exchange would mitigate problems of paddy farmers and political problems propelling out of falling market prices of paddy during harvesting time. Such a futures market could be used for all agricultural products not only to stabilise the prices but also to provide greater liquidity for the producer.

Farming can be a risky endeavour. Weather, pests, and disease can diminish the output. From a field or herd. Changes in prices can reduce revenues or increase costs. Farmers may manage the risks of loss of production due to weather, pests, and disease by using crop insurance and massive price drops due to an increase in supply during harvesting by using agricultural derivatives, such as Futures and Options contracts. The seasonal harvests and occasional bumper harvests always result in increases in supply plummeting the market pieces at times even below the cost. 

Market mechanisms should be made available to farmers who can use agricultural derivatives—such as futures and options contracts—to protect against price fluctuations. These tools can help guarantee farmers to a great extent an established price before harvesting. My attempt through this proposal is to suggest competent authorities of the future government of Sri Lanka to establish a mechanism to trade agricultural futures and options made available to be used by the producers and the end users of the products mitigating risks of unhealthy fluctuations of the prices, farmers getting exploited by the rice millers and suppliers of fertiliser and agro chemicals, etc. Futures contracts could also be used for the producers as a source of liquidity. 

My personal view as an experienced futures trader, the availability of a futures exchange for an agricultural economy like Sri Lanka is a must. For decades the price drops in paddy prices during harvesting seasons have turned into massive political problems and at times resulted in farmers committing suicide. A few sophisticated Sri Lankan rubber exporters use rubber futures contracts traded in the Tokyo futures exchange to hedge price fluctuation risks even breaching exchange control regulations at times due to the non-availability of a futures exchange locally. It is impressive to see how India established the MCX Futures Exchange and helped Indian producers and exporters to mitigate the risks of unhealthy price fluctuations to some extent. 

Rice being the most commonly consumed food, Sri Lanka as a nation has consistently invested in developing infrastructure for paddy farming throughout history. The massive manmade clusters of lakes to collect rainwater and systematically developed irrigation canal networks to deliver water to the farmlands are some remarkable achievements of our forefathers in ancient Sri Lanka which to date is perfectly in operation. Since its independence as a nation, Sri Lanka continued their commitment to developing rice farming and increasing harvest with the deployment of “Gal Oya” development project under the leadership of Prime Minister D.S. Senanayake, “Udawalawe development project” under the leadership of Prime Minister S.W.R.D. Bandaranaike and finally massive “expedited Mahaweli project” under the leadership of President J.R. Jayewardene and Minister Gamini Dissanayake, can be highlighted among many other smaller and medium-scale irrigation projects.

Looking at all the irrigation work from ancient times to now it is clear that the total emphasis on these irrigation programs was aimed at increasing the production of rice. Very little importance was given to keeping stable prices of the paddy market once the supply increased. As I see the only tangible effort in this regard was made when the Government established the “Paddy Marketing Board” to buy the harvested paddy at a reasonable given price from farmers to prevent prices from falling due to an increase in the supply of paddy during harvesting periods of “Yala” and “Maha” seasons. However, due to multiple reasons, the Paddy Marketing Board could not stop massive price drops during harvesting periods. 

Every year the Government imposes a minimum buying price for paddy but none of these steps could hold paddy prices from falling below the cost of production. Even at this very moment, the paddy farmers are facing this problem and eventually, this problem trickles down to a huge political problem. Sri Lanka is not the only country where farmers face such problems of huge price fluctuations due to an increase in supply. As a measure to mitigate this problem futures markets evolved in many parts of the world.

What are Futures Contracts?

A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardised for quality and quantity to facilitate trading on a futures exchange.

The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.

Producers and end users

To explain futures trading let’s continue to use the paddy and rice market as the default example. In this case, the producers are the rice farmers. The end users will be wholesalers or retailers of rice such as chains of local grocery stores like Cargills Food City, Arpico, Keells Super, or Government-owned CWC. The producer is worried if the price of rice will come down while the end user is worried if the price of the rice will go up. While the end users and producers were talking to each other and discussing uncertainties that existed in their operations due to fluctuations in price they figured out a brilliant solution called “hedging”. 

A futures contract is a standardised, legal agreement to buy or sell an asset at a predetermined price at a specified time in the future. At this specified date, the buyer must purchase the asset and the seller must sell the underlying asset and in this instance “paddy” at the agreed-upon price, regardless of the current market price at the expiration date of the contract. Underlying assets for futures contracts can be agricultural commodities—such as wheat, paddy, rubber, tea, coffee, cinnamon corn—or other financial instruments.

The proposed futures exchange would be a great help for farmers to raise capital by selling their future production eliminating exploitation by greedy rice millers or brokers. Needless to say, this would take a huge headache off the Government and the movements of the futures market always give a heads up of the price pressures that are in the pipeline of the cash market thus giving an advantage to the Government to better prepare for market action before all hell breaks loose in the local economy and better govern 

the country

Futures contracts—also just called futures—are sometimes used by corporations and investors as a hedging strategy. Hedging refers to a range of investment strategies that are meant to decrease the risk experienced by investors, producers and end users. The unfortunate event where Ceylon Petroleum Corporation (CPC) lost millions of dollars on their crude oil hedging was purely due to ignorance of the Head of the Central Bank at that time when the transaction was done using a very risky inappropriate strategy of hedging against my written advice against doing so. No one knows about what went wrong with that CPC hedging deal better than me. 

I introduced hedging to CPC and Sri Lanka following a meeting I had with then Foreign Minister Tyrone Fernando in Los Angeles, USA in the latter parts of 2005 during his official visit to the United States while Ranil Wickremesinghe was Prime Minister of the country under CBK administration. It was very unfortunate that CPC ended up losing when the plan was to lock the crude oil price at $ 56 sighting the price was going over $ 100 per barrel. If the crude oil hedging was done properly, most of the local energy market problems that we are experiencing now would not have surfaced ever.

History of futures trading

Futures trading can be traced all the way back to 1750 BCE in Mesopotamia, located in present-day Iraq. You may have heard of the sixth Babylonian king, Hammurabi. He’s best known for creating the famous Code of Hammurabi, which was one of the world’s first written legal codes.

Part of that Code stipulated that goods and assets could be delivered for an agreed-upon price at a future date. For goods and assets to be sold at that price, there needed to be a written (and witnessed) contract.

This part of the code quickly led to a type of active derivatives market. Ancient Mesopotamians would gather at temples to exchange forward and futures contracts.

The earliest recognised futures trading exchange is the Dojima Rice Exchange, established in 1730 in Japan for the purpose of trading rice futures.

 Western commodity futures markets started trading in England during the 16th century, but the first official commodity trading exchange in England, the London Metals and Market Exchange, was not established until 1877

The United States had the earliest official commodity trading exchange in the West, the Chicago Board of Trade (CBOT), formed in 1848.

Founded in 1848, the Chicago Board of Trade is a well-known commodity exchange in the USA. This exchange was used for trading agricultural commodities in the beginning stage. It was formed to help farmers and commodity consumers of corn and wheat. CBOT focuses on managing risks by eliminating price uncertainty from these products.

The headquarters of this organisation is in Chicago. Notable achievements of the Chicago Board of Trade include introducing futures contracts on products like cattle and other livestock and trading contracts associated with financial products, metals, and energy. Later, options contracts were introduced to help traders and investors improve their risk management strategies.

The CBOT arose in the aftermath of railroads and the telegraph connecting the agricultural marketplace hub of Chicago with New York and other cities in the eastern US. The first traded futures contracts in the US were for corn. Wheat and soybeans subsequently followed, and these three basic agricultural commodities still account for the bulk of trading business conducted at the CBOT.

The next large market to begin trading futures contracts was the cotton market. Forward contracts in cotton began trading in New York in the 1850s, leading eventually to the establishment of the New York Cotton Exchange (NYCE) in 1870.

 Futures contracts for other products developed over time, including commodities such as cocoa, orange juice, and sugar. Massive US cattle production led to cattle and pork futures contracts.

In the 1970s we saw a large expansion in the futures trading markets. The Chicago Mercantile Exchange (CME) started offering futures trading in foreign currencies. The New York Mercantile Exchange (NYMEX) began offering trading in various financial futures, including US Treasury bonds (T-bonds) and eventually futures in stock market indexes. The Commodities Exchange provided futures trading in gold, silver, and copper, and later added platinum and palladium when gold ceased to be pegged to the US dollar. The rapid expansion of trading in financial futures led to the creation of futures contracts on the Dow Jones and S&P 500 stock indexes.

As you read about the formation and development of CBOT, you will begin to understand the way it helped the producers and end users mitigate the risk of price fluctuations thus stabilising prices.

Multi Commodity Exchange (MCX) was formed in India in 2003 enabling Indian producers, exporters, and end users to hedge price fluctuation risks. In 2005 a senior director of MCX was in Sri Lanka to find out the possibilities of forming a limited agricultural futures exchange to mitigate risks of huge price fluctuations. If requested at the state level Indian government or the MCX would extend their fullest cooperation to the government of Sri Lanka to establish a local futures exchange to heal the wounds of the farming community which is a large cross-section of our society created by the price drops during harvesting, at times ending up in suicide.

There are not many solutions for the price-related grievances of the farmers and introducing an agricultural futures hedging will surely not eradicate all price-related problems of the farmer but it could mitigate the problems propelled by price fluctuations to a great extent. These commodity futures contracts could be traded side by side along with stocks at the Colombo Stock Exchange to start with, on a different platform. Once the speculators get on board the price risk of the producers and end users get pushed into the hands of wealthy speculators which would have a profound impact on the economy with much stable prices. The proposed futures exchange would be a great help for farmers to raise capital by selling their future production eliminating exploitation by greedy rice millers or brokers. Needless to say, this would take a huge headache off the Government and the movements of the futures market always give a heads up of the price pressures that are in the pipeline of the cash market thus giving an advantage to the Government to better prepare for market action before all hell breaks loose in the local economy and better govern the country. 

The local Securities Exchange Commission unfortunately is not very knowledgeable about futures trading until they are provided with comprehensive training and it is a must to get help at the State level from existing major futures exchanges to establish a local futures exchange. 

The local futures exchange could get expanded to tea, rubber, coconut, cinnamon, etc. The establishment of a local futures exchange would be something that the Sri Lankan farmer or any of the future generations to come would never forget. This could save them from the never-ending miserable saga of price drops to a great extent. Elsewhere in the world, market-based solutions for agro-based product price drops have been used efficiently to protect both the farmer and the end user. We are not too late to bring this time-tested system home to protect both the farmer and the food security.

(The writer is former currency strategist, commodity futures trader, and technical analyst.)