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

Posted on by MSC

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.

Self-help groups: How to empower rural women and make financial services accessible to them

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Yeredeme Group (GYD), which means “self-help groups” (SHG) in Bambara, is an innovative methodology for rural women’s empowerment based on self-management and peer-learning activities. Its implementation was possible thanks to a technical partnership between an Indian NGO, the Manjari Foundation, and the Malian NGO, CAMIDE. The model integrates livelihood activities development, financial intermediation, women’s empowerment, and community development.

With the Yeredeme methodology, more than 2,500 women from 19 villages in the Logo municipality in Mali have been organized into 189 SHGs. These women were granted microcredits regularly in the SHGs. In addition, they also benefited from larger refinancing loans disbursed by Benso Jamanu, the financial branch of CAMIDE.

SCBF, the Swiss Capacity Building Facility, is an organization that provides technical assistance to financial services providers to help them build the expertise needed to develop client-centric financial products. With SCBF’s support, Benso et CAMIDE has extended the Yeredeme methodology in two additional rural municipalities (Sero Diamanou and Liberte Dembaya).

The goal is to reach 5,000 women (households) with the Yeredeme groups methodology by creating the following grassroots women’s institutions: 320 SHGs in 40 village organizations and two federations. As Yeredeme groups are rooted in self-management, peer-learning activities will focus on building the capacity of women whose role will be to support the setup, management, and development of 60 CRPs (community resource persons), 320 Sebennikela (group accounting secretaries) and 40 control officers.

The SCBF commissioned this study to understand the Yeredeme methodology’s effects on clients.

Decoding agriculture market linkages for FPOs: Lessons from the field

Posted on by MSC

India’s farmers have had a long history of struggle. For decades, they have battled a multitude of agricultural challenges, such as fragmented landholding, numerous intermediaries, and low value addition. In response, the country has actively promoted farmer producer organizations (FPOs) as a solution. FPOs intend to address these serious issues through the aggregation of demand for high-quality inputs, credit, and technologies and the aggregation of outputs to improve smallholder farmers’ market access.

Yet despite these efforts, major processors and output purchasing companies hesitate to engage directly with FPOs. This blog explains the options available for FPOs to trade with institutional buyers and the on-ground issues FPOs must overcome to establish better market linkages. We limit the discussion to cereals and grains, which constitute most of India’s agricultural production.

Agriculture value chain participants

We have used Bihar’s maize supply chain as an example to depict the commodities’ journey from farmers to end processors. In Bihar, farmers typically have an average landholding of only 0.38 hectares, which produces around 2-5 metric tons (MTs) of maize per season. Farmers sell more than 90% of the total produce in Bihar directly at the farm gate to village-level aggregators. These aggregators, in turn, sell the produce to small traders, who then supply it to large traders. The major processors and trading firms serve as the primary buyers for these large traders. They collectively procure millions of metric tons of maize from Bihar each year.

The intermediaries, such as aggregators and traders, are critical in the conversion of small amounts of 2 to 5 MTs into hundreds of thousands of MTs as required by the large buyers within a short period of 30-45 days. Throughout this process, the material is graded into different qualities, which allows the buyer to buy the desired grade. The following provides a generalized representation of participants in the commodity value chain.

Figure 1: Agriculture commodity value chain—from farmer to institutional buyer

What avenues do FPOs have to engage with large institutional buyers?

FPOs often act as substitutes for aggregators and small traders. A primary motivation behind FPOs’ formation is to bypass intermediaries and establish direct trading channels with food processors and other significant institutional firms. In this section, we have listed different trading approaches FPOs can take to deal with large buyers:

1. Daily supply based on daily prices: FPOs can engage in daily commodity trading if they receive prices every morning. Large institutional buyers typically have designated locations, such as warehouses, for delivery during the harvesting season. Under this method, the FPO receives daily prices from the buyer, factors in operational expenses, and determines the procurement price for the day. Interested farmers make deals with the FPO, which procures and delivers the produce to the buyer’s delivery center. This process minimizes FPOs’ price risk as it treats each day’s material as an independent trade. However, operational efficiency is crucial to maintain sufficient margins. For example, the FPO should plan the procurement quantity from farmers in a way that it can fill the trucks deployed. If the trucks’ space is not filled, the produce’s transport cost will increase and eat into the margins. Similarly, the quality should be good enough to ensure the trucks are accepted with no deductions at the buyers’ warehouse.

2. Large quantity trades with fixed terms (“sauda”): Another method involves the execution of large trades at a single price point within a limited delivery period, commonly referred to as “sauda.” Large institutional buyers widely adopt this method. It entails an agreed-upon quantity, price, and quality to be delivered within a fixed time. While this method allows for slightly better prices and provides a fixed price over a specific duration, it comes with risks. FPOs must meet their commitments to avoid fines or jeopardizing future trades, which makes operational maturity crucial.

3. Storage of commodities to sell in the future: The usage of accredited warehouses for storage with the intention of future sales is often suggested to secure higher prices. However, our practical experience reveals that this approach is also the most precarious. Commodities’ storage introduces additional expenses, which include costs of carry or storage, susceptibility to market price volatility, shrinkage or storage losses, and heightened financing requirements. Professional warehouses always come with a mandatory minimum lock-in period, which significantly increases costs. This may result in FPOs achieving minimal profit margins despite price appreciation. Market price risks, influenced by global supply chains and external factors, further compound the challenges.

A comparative analysis in the table below illustrates two scenarios: In Scenario 1, FPO ABC stored wheat for nine months, and in Scenario 2, FPO XYZ stored maize for 10 months. While FPO ABC realized a profit of USD 3/MT, FPO XYZ’s profit was only USD 0.87/MT. Notably, despite the maize price appreciation, FPO XYZ experienced a reduction in profit margins due to associated storage costs. Both FPOs had internal financing. If external credit was involved, the interest rate during the storage period would have further eroded the FPOs’ profit margin.

Table 1: Economics of storage of commodities and sales for two FPOs

Despite these risks, storage remains an important avenue for market linkage in regions without a significant presence of large buyers. This requires the produce to be transported to distant locations for sale to a large institutional buyer. FPOs must constantly check the arbitrage in prices available and the various costs associated with storage.

4. Delivery to distant locations or interstate transport: Large buyers often offer better rates closer to their processing units, which may be located far from the FPOs or in other states. FPOs must transport produce to these distant locations in such cases. The main risk involves quality checks at the designated delivery location. If the quality does not meet expectations, the price received may decrease, or the material could be rejected. This would lead to distress sales in unfamiliar geographies. A reliable network with transport agencies is crucial to tap into this opportunity.

What challenges must FPOs overcome to establish efficient market linkages?

MSC has highlighted the internal weaknesses that FPOs must overcome in other blogs. In the following section, we list specific operational areas that FPOs must strengthen to meet the challenges presented by the markets:

  1. Ensuring ruthless quality control: FPOs need to compete with aggregators and small traders through efficient procurement of the right quality at the right price. Educating farmer members in advance is crucial. Although the FPO belongs to them, it cannot compromise on the prevailing quality standards in the market. The price the FPO offers for a specific quality must align with market practices.
  2. Identification of different buyers for different quality: As social organizations, FPOs are obligated to buy different grades from their member farmers. Therefore, FPOs must identify various buyers for different quality grades. The FPO, Aaranyak Agri-Producer Company Limited (AAPCL), Purnea, has built relationships with many maize buyers. These include poultry feed manufacturers, who require higher quality produce; starch manufacturers, who are fine with slightly lower quality maize; and local producers of industrial ethanol, who are not quality conscious.
  3. Creation of suitable structures to scale: FPOs struggle to scale up as they face operational challenges, such as maintenance of procurement quality, arrangement of cost-effective logistics, and proper documentation for procurement and sales. Traditional field staff may not be a sufficient operational structure for scaling. JEEViKA-promoted FPOs have addressed this through a network of agriculture entrepreneurs (AEs). These AEs are educated youth in the villages and provide aggregation services to FPOs on a commission basis, which is linked to the quantity and quality of procurement. For example, Aaranyak FPC in Purnea collaborates with 12-14 AEs every season. This has helped the FPO increase annual maize procurement from 1,200 MT in 2020 to 4,150 MT in 2023. This approach has proven effective to enhance the FPO operations’ scale.

In conclusion, the complexities of market linkages for farmer producer organizations (FPOs) in India reveal both challenges and opportunities. We must appreciate and respect the current market structure and rules as the nation actively promotes FPOs to surmount structural issues in agriculture marketing. FPOs must overcome challenges, such as quality control, identification of diverse buyers, and creation of scalable structures, to thrive in the evolving agricultural landscape.

 

Leveraging AI for climate resilient agriculture: 2023 financial inclusion week

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In the evolving landscape of AI for agriculture, the future lies in hyper-personalization and multimodal models. AI will increasingly use diverse data sources, which include images and videos, to offer personalized solutions. The focus is on enhancing localization, predicting trends, and addressing challenges, such as climate change and market fluctuations. As AI becomes more integrated, institutions should embrace its transformative potential to benefit smallholder farmers, ensure the services are tailored to their unique needs, and contribute to a more sustainable and resilient agriculture ecosystem.

Leveraging AI for climate resilient

Posted on by MSC

Our recent work in Bihar highlighted climate change’s persistent impact, which led to disruptions from heat waves, droughts, and floods over the past decade. This has led to a significant increase in pest infestations for farmers. Bangladesh also observed similar challlenges where extreme heat and saline land from previous cyclones complicated land preparation. Erratic rainfall delayed and dried seeds, followed by torrential downpours that flooded and washed away crops. Cyclone Amphan further worsened conditions. It wiped out standing crops and introduced saline water, which made the soil less fertile. We worked with CGAP in Bangladesh and DECODIS in Nigeria on a macro scale and found climate change’s adverse effects on livelihood capitals. Now, in collaboration with the Government of India, Agristack, and the Government of Bihar, we intend to address these challenges by integrating a digital farmer services platform, which uses technology to enhance agricultural production, financing, and market linkages.

Voices of India’s MSMEs: Insights notes from The Diaries – Edition 1

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The first note in this series of notes—Insights note-Edition 1—covers aspects related to the business finances of informal enterprises (IEs) and how external factors affect them. It also unpacks informal enterprises’ adoption of digital technology and how they use it in business.

The note discusses examples from MSC’s Financial Diaries research on IEs to validate the findings. It also provides recommendations for policymakers and financial service providers to address IEs’ challenges.