Wednesday, December 02, 2009
Who Should Be Blamed For Problems In The Grain Futures Market?
Someone’s money is being pumped into and out of the commodities market every day, with world events being cited as the reason, not necessarily crop size, demand, and other fundamental factors that farmers can grasp and understand. And between January of 2004 and June 2008 the new money that entered the trading pits represented a 216% increase in open interest for corn, wheat, and bean futures. Many skeptics blame a variety of different trading groups as scalawags who have profited at the cost to farmers, whose hedging practices have become neutered by the imperceptible volatility in the market. Just who are these scalawags?When commodity prices were launched into the stratosphere, farmers were pleased they had finally been rewarded for their hard-earned efforts. However, the ensuing reversal of fortune did not result in farmers halting their crop production efforts, so it must have been someone else who was responsible for the market decline. USDA’s Economics Research Service (ERS) investigated the flow of capital in and out of the markets totaled hundreds of billions dollars worth of initial and maintenance margins. The ERS report began with the allegations that flew in the energy market as oil prices climbed toward $150 per barrel. One of the problems cited by farmers was the failure of convergence between cash and futures market, threatening the ability of the futures market to be a useful price discovery system. That raised numerous other questions and concerns.
The economists describe typical trades as commercials, who hedge to manage their risk of price movements of cash grain; and non-commercial traders who trade with the objective of achieving profits through successful anticipation of price movements. But they say over time the line between the two has blurred and the behavior of the two is a continuous line connecting risk avoidance and pure speculation. The large speculators, which began trading commodities in the 1980’s, used technical trading patterns to move money in and out of certain contracts and were less interested in the market fundamentals of supply and demand. The entry of electronic trading eased the process and reduced the cost for fund managers and is now the dominant form of contract trading in the grain pits. Additional new tools, such as swaps that are derived from futures contracts, and spreads that allow traders to extend their hedge well into the future, have contributed to the changes underway in commodity exchange pits.
The new market participants are index funds, whose shares are sold to investors with a manager charging a fee for services. The investors reduce their portfolio risk by diversifying as a hedge against inflation. They are not involved with the physical commodities, but are classified as a commercial trader to take advantage of lower margin requirements. Regulators approve, since the fund sells a collection of futures contracts to investors, just not the physical commodity. Index funds have been under scrutiny, but so has the managed money funds because of their greater access to agricultural commodities. A managed money fund is a managed portfolio of commodities only. The wide range of new investors and their investment companies, all of which are trying to reduce risk and maximize profits, has altered the mix of traders say the economists. But they rhetorically ask, what group is dominating the futures market? And they answer, by saying the bottom line is not speculation versus value creation, but whether the futures market is being harmed. The economists point to a number of academic studies that show specific groups of traders are not to blame for problems faced by the market.
Since accusations have been leveled at index funds, the economists looked at their track record of buying and selling futures contracts. They say index funds changed their positions more gradually than did commercial and non-commercial traders, and were generally in a net long position from January 2006 to the spring of 2009. And the economists ask if the index traders were not the cause of increasing prices, then what was the cause? Other researchers have suggested higher prices resulted from: ethanol mandates, foreign demand and purchasing power, number of potential customers in the market, and prices of substitutes all boosting demand for commodities.
The problems in the futures market related to the linkage between cash and futures prices points to a weakening of the link with unpredictable basis levels and lack of convergence between cash and futures at the expiration of the contract. Transaction costs, which have an impact, include barge load out, storage, and interest opportunity cost, and will all keep the basis from being zero, but should be less than 10 cents per bushel. The economists point to the basis of expiring new crop corn, wheat, and bean contracts which have varied widely in recent years and suggest the reason may have been insufficient load out capacity at delivery locations, lack of incentives to engage in arbitrage, and an outdate delivery system. The CME Group, which operates the Chicago Board of Trade, obtained regulatory approval before taking several steps to upgrade the delivery system and implement some of the related suggestions. Following that, studies found improvements in the cash and futures convergence in the corn and bean contracts but problems remained with the wheat contract.
So what if the cash and futures do not converge when they are supposed to do so? That means commercial traders, such as grain merchandisers and grain elevator have hedging difficulty and must also cope with large margin calls on short hedges. The Kansas City Federal Reserve Bank recently found that 1 out of 4 commercial traders was struggling to acquire the cash needed to manage margin calls. They headed to credit markets, and if requests were declined, they quit offering forward price contracts that curtailed risk management opportunities for their farmer customers. During futures periods of price volatility, the economists say farmers will find that grain elevators will offer less attractive pricing opportunities with a wider basis to protect their interests. While farmers themselves could hedge, they would face the same credit issues that face elevator managers or enter into a basis contract to eliminate basis risk.
Summary:
When cash and futures contracts were not converging as the grain market expected, criticism was leveled at segments of grain traders who were thought to have contributed to the volatility in the market over the past several years. Various studies have cleared those who were accused, but when the convergence problems remained, several changes were made in futures contracts that successfully addressed the corn and soybean contracts, but not wheat. Those convergence problems cause hedging challenges to grain elevators, which protect their financial position by restricting risk management tools available to farmers.
Posted by Stu Ellis on 12/02 at 02:32 AM | Permalink