Cotton futures hedge
trading was carried-on in the Karachi Cotton Association (KCA) from 1934
to 1975-1976, it was suspended due to the nationalization of the cotton
trade by Pakistan government. In letter dated 29 April 2002, the
Ministry of Commerce, Government of Pakistan constituted a committee for
cotton hedge trading in Pakistan. This committee comprised of
representatives of cotton growers, ginners, State Bank of Pakistan,
Securities & Exchange Commission of Pakistan (SECP), ADBP, APTMA,
discussion, the Committee's view was that if the government permits
hedge trading in cotton, it should be managed by KCA, which had the
requisite experience, expertise, trading hall, manpower and brokers. On
June 21, 2002, the KCA submitted to the Minister of Commerce the report
of the committee on Cotton Hedge Trading in Pakistan.
You are aware that cotton
and its products comprise 65% of the total exports of Pakistan. Also
that the total production of cotton in Pakistan is not sufficient to
meet the total requirement of the cotton textile mills and the cotton
and textile trade in Pakistan. Our proposal was, therefore, carefully
prepared to prevent "Cornering" and all other aspect for
smooth operation of the market.
The SECP did not
participate in the deliberations of the Committee because as stated by
them, "it regulates matters relating to listed securities." It
further stated that if the proposal relates to the formation of a
forward or spot market in cotton, then it would fall outside the purview
of the SECP. However, if the Committee is working on securities relating
to future contracts in cotton, then the matter would require the
specific approval of SECP, who further stated that "future
contracts based on commodities are derivative securities".
to the DERIVATIVES DICTIONARY, a derivative product is a financial
contract whose value depends on a risk factor, such as
The price of a bond, commodity, currency, share, etc.
• A yield or rate of interest.
• An index of prices or yields.
• Weather data, such as inches of rainful
• Insurance data, such as claims paid for
a disastrous earthquake or flood, etc.
Also known as "derivative", for short.
The proposal made by the
KCA is not a speculative contract based on the price of cotton but is a
cotton hedge forward contract to enable all stakeholders to trade or
export cotton and its products by making Forward Cotton Hedge Purchase
or Sale Contracts.
In this connection, I
give below relevant extracts from an article written by Mr. Umar Latif
in "The News on Monday, 6 January 2003".
inspiration, intertwined with unlimited support and promotion extended
by the Securities and Exchange Commission of Pakistan (SECP) and to
begin with, the Karachi Stock Exchange Limited has given 'birth' to a
subsidiary company, named National Commodities Exchange Limited (NCEL),
The managing director of the KSE bas been appointed also MD of the NCEL.
There is a whole world of
difference, to put proverbially, between stock which refer to shares of
public/quoted/listed corporate entities and commodities produced in
farms. The corporate entities, shares of which are traded in prescribed
lots, known as stock, consist of trading, manufacturing, processing
enterprises and others of providing services including financial.
These enterprises need
funds larger than their sponsors can contribute. So, they offer part of
equity to the public. Those having surplus funds invest in shares of the
companies and share in incomes to be generated by their business
activities. Thus, besides the sponsors collecting required funds, idle
funds with those not having acumen of floating their own business, get a
place to put money and reap benefits. Assets created by the investments
are rendered 'liquid' in form of ownership share, evidenced by
certificates issued by the companies, which are traded on the stock
markets. This facilitates change in ownership interest without hassle.
This underlines need and gives justification to existence of stock
exchanges, known as 'capital' markets, providing a place for change of
hands holding equity interest.
What about the 'future
contracts' markets? Do they similarly deal in stock of commodities
specified? This implies a lot of difference between the two. 'Future'
contracts are meant for commodities. Commodities have, besides national,
wider international markets. A country cannot produce all the
commodities its people consume. This has rendered trading in commodities
a complex global phenomenon.
Providing stock brokers
an option of trading in 'future contracts' of stocks, by opening up
'forward counter', consisting of large sized capital and floating stocks
companies was in itself an objectionable act on the part of the SECP. In
shares, forward trading and future contracts bear no justification.
Stocks are not commodities, that hedge of them would be a necessity. It
is merely making room for speculative tendency.
Come back to the core
issue of: 'is it appropriate to make stock markets simultaneously
commodities markets dealings in 'future contracts'? Future contracts are
meant specifically for commodities needed by people for consumption. At
all times and places, their production tends to be uncertain, due to
several natural factors, such as climate, drought, certain unexpected
natural and environmental changes. Supplies and demands for commodities
have to be managed in good order, so as to avoid undue bullish price
spurts as well as drops on bearish beatings. Producers and consumers
have to be protected from uncertain price trends, so as to serve both
the ends well. The art of doing so is in organizing future contracts,
taking place through out the year irrespective of short span of seasonal
arrivals. Most of the consumers and producers are accustomed with the
actual purchase and sale of commodities in certain lots.
But to manage the entire
volume well and round the year, though commodities arrival time would be
of three to four months, the commodities tend to be subject to
'something more mysterious i.e. purchase and sale in bits of paper'.
These bits of paper are known as 'commodities future' contracts that
brokers deal on behalf of their principals. Often the brokers turn out
to be jobbers, having experience to benefit from others expertise, later
acquired by major players of the markets and so often their being
producers and consumers of such commodities. 'Future contracts' trading
in commodities serve as a safeguard to both producers and consumers
interests. The art of balancing act in prices movement, avoiding
contrasting spurts, is known as 'hedge'. It is also known as arbitrage
overcoming distances of commodities supply sources in giving stable
price trend. Prices move at a steady pace and by informed decision.
Specialisation Trading in
commodities, like cotton, sugar, oils, rice, jute, wheat etc. is now a
global phenomenon. Major exchanges for them exist in main trade centres,
like London, New York, Tokyo, Paris etc. Having identical set up in
Pakistan for key commodities is as much imperative as elsewhere. Working
in the given network demands specialisation. For the purpose,
specialized institutions need to be created and promoted. These were
here in Pakistan nearly three decades ago, prior to the 'speculative'
trading banned during the 1970's. The SECP ought to have exercised care
and restraint in giving permission to stock exchange take a lead in
creating 'NECL' and begin future contracts in commodities."
With global trading under
the auspices of WTO fast approaching; in order to protect & improve
our cotton products 65% share in the export economy of Pakistan, it is
essential that the government immediately permit the opening of KCA
Cotton Hedge Market.
"Derivatives", I refer to an interesting article, which
appeared in the US magazine "FORTUNE" dated March 17, 2003.
Mr. Warren Buffett is the doyen of the New York Stock Exchange and has
successfully operated there for more than 60 years. He has termed
"DERIVATIVES" as financial weapons of mass destruction.