THE Securities and Exchange Commission approved the listing of wheat futures contracts on Pakistan Mercantile Exchange Limited on April 24th, subject to cabinet approval.

Settlement through Electronic Warehousing Receipts and hedging against price risk are reported to be the main objectives for listing of wheat futures on PMEX.

The government already has a mechanism in place to fix the support price of wheat, and therefore there is no need of futures contract in wheat to hedge against price risk.

In general, the inclusion of derivative products in the Eighth Schedule of Finance Act 2016 along with legislative and infrastructural inadequacies are inhibitors to flight of commodity market derivatives.

The government procurement with imported volume is sufficient to influence market prices and create an effective price floor in the domestic wheat market

In terms of prices, domestic farmers and private traders face relatively little price risk as the government determines prices. Farmers and millers have little incentive to manage risk on their own behalf under current price stabilisation policy.

The government undertakes the risk by buying at a variable international price and selling at a fixed domestic price.

The price of wheat has always been a political issue, even a small change in its price and availability is perceived to have profound effects on national economy. The government policies regarding support price, release price, and ex-mill price are least likely to go away any time soon.

Listing of wheat future contracts on PMEX may be an addition to the trading ecosystem but apparently, it will not have an impact on price stability. The government fixes and announces a support price each year before the harvest; and provincial food departments release wheat to flour mills at fixed release prices on the basis of a quota system.

Future contract is a risk mitigating tool where the hedger takes same but opposite position in future market compared to spot market; successfully eliminating the price risk in theory.

A hedger should cover all cash transactions with futures contracts however, in practice the prices on the spot and future markets do not move exactly together due to unpredictability of actual price movements.

Since the effectiveness of hedging depends on the difference between the future price and actual price, controlling the actual price reduces the effectiveness of hedging and the futures contracts will not serve the intended purpose.

Federal and provincial food departments procure about 60pc of the total marketable surplus of wheat. The government procurement with imported volume is sufficient to influence market prices and create an effective price floor in the domestic wheat market.

In case of wheat futures the market would be pitted against giants; while the wheat support price is a major driving force on the supply side, high tariffs have prevented wheat imports.

Futures are either settled against delivery or cash but in the case of the PMEX wheat futures contracts, a compulsory delivery is one of the salient features of the instrument.

Wheat procurement and storage offers huge business opportunity for private sector. The private sector, primarily wheat traders and flour millers, have less than 1m MT of grain storage capacity against purchases of 2m MT of wheat from the farmers each year.

Thin and outdated public sector storage with no loss policy on storage encourages slack storage practices and a lucrative financing and storing activities to banks and private sector.

Many banks and private parties have shown interest in investing in the collateral management companies and wheat storing silos, which is a critical component for putting in place electronic warehousing receipts.

The State Bank of Pakistan has consulted with Pakistan Bankers Association and with other stake holders regarding building contractual framework on Electronic Warehouse Receipt system (EWR) through consensus.

Warehousing is good for commercialising and financing agriculture activities. Warehouse receipts are the negotiable instrument which can be used as a form of portable collateral to request loans from banks, and are issued by the licensed and regulated warehouse operators, when the commodities are stored.

Many countries have bitter experience regarding EWR without a warehouse receipt law. Relevant laws like Agricultural Produce Market Act, 1939, Punjab Agricultural Produce Markets Ordinance, 1978 and Sindh Registration of Godowns Act, 1995 do not address the issues related to warehouse registry.

The contractual framework will not enable parties to pass good title under the prevalent legal framework. For the futures to be traded the receipts must be freely transferable by electronic delivery and return on storage will be market based.

The concern here is implementation of EWR without the enactment of Warehouse Receipt Law. The development of regulatory authority and slow adoption of system by all parties will make the underlying objectives redundant.

Slow capacity building on financial awareness is an impediment to adoption of Electronic Warehouse receipt specifically in farming community. Subsequently low penetration will lead to speculating activities rather than hedging.

Listing of Wheat futures on PMEX may be another feather in the government’s cap or it may be part of financial inclusion strategy 2020, but it cannot yield dividends as risk hedging tool.

Creating a warehouse registry cannot merely be done by including collateral management companies in the draft of company’s ordinance 2016. Viability of the electronic warehouse receipt registry does not depend on cost alone; the system must be based on legislation, rather than on private contracts among its parties.

Issuing credit is simplified as the banks have access to pledges but in the case of changing ownership of receipt where a position is hedged against other position the issue does not remain so simple.

—The writer is a career investment banker.

Published in Dawn, The Business and Finance Weekly, May 8th, 2017