The 2018 Agricultural Commodity Futures Conference was held in Overland Park, Kansas on April 5-6, 2018. This meeting was sponsored by the Commodity Futures Trading Commission and the Center for Risk Management Education and Research in the Kansas State University Department of Agricultural Economics.
The agenda for this conference and an number presentations are available at the following web location:
Following is the first of two articles by KSU Agricultural Economics Art Barnaby and Daniel O’Brien discussing the findings of the conference – with a particular focus on the functions, efficiency, and performance of grain cash and futures markets. This article is also available at the following web address on the KSU AgManager.info website:
Fixing Arbitrage to Cause Convergence; No Consensus
G. A. (Art) Barnaby, Jr. (firstname.lastname@example.org) , Professor, Dept. of Agricultural Economics
Daniel O’Brien (email@example.com), Extension Agricultural Economist
K-State Research and Extension, Kansas State University, Manhattan, KS 66506
April 16, 2018.
Kansas State University and the Commodity Futures Trading Commission (CFTC) recently held a joint conference on the lack of convergence in grain futures and many other futures trading issues. Convergence is required for COOPs, grain elevator hedges, farmer hedges and crop insurance claims to work properly. Without convergence, there is no connection between futures and cash markets, and grain future markets are not likely to survive in the long run without a reliable basis relationship with local cash prices. Futures are not trading grain; they are trading the value of a shipping certificate that is received by the long when delivery occurs. Non-convergence occurs when there is no credible threat of delivery. Shipping certificate receivers have the right to store the grain and pay the storage indefinitely, currently 5 cents/month for corn and soybeans. They also have the right to pick the date to load the grain out on a train/barge.
Most grain industry traders don’t favor the Variable Storage Rate (VSR) mechanism now used on Chicago Mercantile Exchange (CME) Wheat futures contracts, and it appears there is little chance that VSR will be applied to corn and soybeans. Other options for defining storage obligations in the CME wheat futures contracts included: 1) returning to a fixed storage rate; 2) fixed storage at a higher rate; 3) a seasonally adjusted storage rate; 4) a computer model estimated implied market “value of storage” with a committee adjusting the storage rate; 5) expanding the number of entities who can make delivery; and 6) a change to a no-storage futures contract. Most participants at this conference were opposed to cash settlement and required load out of grain futures.
Indexed funds, computerized trading, “Spoofing”, livestock contracts, etc. were also covered at this conference, but not included in this summary. Papers and power point slides from the conference are located at:
Issue #1: CME Algorithm
CME has eliminated pit trading in favor of computerized matching of buy-sell orders. Surprising, it is not the oldest futures contract bid that is filled first. To the surprise of many participants, CME has an algorithm that determines which contracts are filled first. There was one very upset participant that stated his order was not filled, even though his bid was higher than CME’s posted close. His question was how was that possible? Answer, that is how the algorithm works[ii]. Some participants questioned the “equity” and “fairness” of a CME algorithm determined queue order for filling contracts. (See note at end of article on how the CME Algorithm functions)
Issue #2: Variable Storage Rate (VSR) Mechanism for CME Wheat & KS HRW Wheat Futures
As expected the Variable Storage Rate (VSR) generated a lot of discussion. There were a number of grain traders who made it very clear they don’t like VSR. The argument is VSR leaves the long guessing what the storage cost will be, resulting in reduced liquidity in the deferred contracts.
Dr. Scott Irwin, University of Illinois, made the case that non-convergence was caused by the futures stated storage rate being set below the market value for storage. Multi-national grain elevators with delivery rights don’t deliver grain, they deliver a shipping certificate that only they can create. In addition to delivery, these certificates are sold in a secondary market, but they will sell at a price that is higher or equal to the non-convergence. If one could buy shipping certificates and gain by arbitraging the futures, then the arbitrage profit would be bid to zero almost immediately.
Dr. Irwin, as the acknowledged primary developer of the VSR, surprised many participants when he didn’t strongly defend it. He spent most of his presentation talking about non-convergence in the corn market, rather than the wheat market. He appeared to be more supportive of using the results from a mathematical model’s estimated “market” value of storage, and then a designating committee to determine whether to make any adjustments to the storage rate. If the CME wants to use a different model to adjust the storage rate and the math is made public, then one would expect that to work too. However, if there is a committee that makes the final decision, then it adds another level of uncertainty; will they act or just go with the status quo? This committee would likely add a whole new round of controversies about trading futures.
He also suggested that a seasonal storage rate might work for corn. If one remembers after the first round of non-convergence in KC wheat in the early 2000’s, the exchange added a protein requirement for the first time and a seasonal storage rate. However, those changes didn’t prevent the most recent round of non-convergence in HRW wheat. Apparently indicating the higher seasonal rates applied at that time were not sufficient to bring about convergence in the HRW wheat futures contract.
Issue #3: No Storage Grain Futures Contracts
One participant argued for no-storage futures contracts. Without a storage requirement, it would allow more entities to make delivery and arbitrage futures contract. Alternatively, CME argues there is only one new crop supply provided each year (two, if you count Brazil) therefore, futures must include storage so that a market mechanism exists to reflect grain prices and grain storage costs. Those supporting a “no-storage futures contract” counter that clearly someone will store grain, regardless of the futures contract. They state that there are plenty of farmers who are willing to store grain and most of that grain is unpriced. They indicate that markets will need to provide a return to storage, even with a no-storage futures contract, but that may require higher deferred prices.
Issue #4: Including Farmer Storage In Delivery of Grain Futures Contracts
Another participant suggested CME should allow farmers to store the grain at the futures storage rate, when delivery elevators don’t want to store grain. The storage would need to be certified by USDA, utilizing local Farm Service Agency (FSA) offices would likely be certification of choice. There would also be questions in the case of farm bankruptcies, whether the long still owns the grain the buyer has paid for plus the storage? For this delivery alternative to be workable, there would need to be rules and procedures developed on how the grain would be moved from farm storage to load out on a train/barge.
One of the grain merchandizers attending suggested that farmers should have their futures orders filled first. As explained above, CME’s algorithm determines order that contracts are filled, and that the mechanism used by the CME within that algorithm is not transparent to the public in general or to farmers with futures positions in particular.
There was still no agreement on what the true cash price is for wheat, but at least everyone agreed there was non-convergence in wheat markets. One participant wanted the protein requirement in the futures contract raised from 10.5% to 11%. Currently, the Kansas HRW wheat futures contract does require 11% protein, but will accept 10.5% protein with a $0.10 per bushel discount. It was surprising that many conference participants essentially considered the Kansas HRW wheat futures contract protein requirement to be the discounted 10.5% protein level rather than the 11% par value as stated in the contract.
One key takeaway from this conference was that nearly all of agriculture agrees that convergence is necessary for short hedges and crop insurance to work. Proposed fixes include VSR, a model determined storage rate with a committee to make the final decision on storage rate changes, fixed storage at a higher rate, a seasonal adjusted fixed storage rate, and no-storage futures contracts. However, there was no consensus on what if any changes to make to futures to cause convergence. Among these participants, there was little support for strictly requiring “forced” load-out or cash settlement of grain contracts. They did agree that if there is no connection between futures and cash, then the grain futures are unlikely to survive.
Lack of convergence also effects crop insurance as tool to cover a farmer’s short hedge. Crop insurance coverage combined with CME hedging tools will be covered in the next AgManager update.
An Additional Note on How the CME Matching Algorithm Works
A grain trader provided us with the following response on how the CME order matching algorithm works.
“Almost all of the CME ag contracts are matched using tag 1142 (Match Algorithm Value) = “K” (“Algorithm K”). CME generically defines Algorithm K as a “split FIFO/pro-rata algorithm.” However, there are multiple rounds of allocation under Algorithm K:
- Round 1: Top-Order Allocation: A top order allocation is given to the first incoming order that betters the market and is filled at a 100% between a minimum of 1 lot and a maximum of 100 lots (note the maximum for KC wheat contracts is 50 lots).
- Round 2: Lead Market Maker Allocation: CME makes various vague statements about there being the possibility of a “lead market maker allocation” after the top order allocation. None of the CME’s published materials confirm whether there is a lead market maker allocation for the ag contracts and, if so, how big is that allocation?
- Round 3: FIFO Allocation: 40% of the volume after the top-order and LMM allocations is allocated via FIFO.
- Round 4: Pro-Rata Allocation: 60% of the volume after the top-order and LMM allocations is allocated via pro-rata, with order size and time being the variables for allocation.
- Round 5: Top-Leveling Allocation: Any participant that did not receive an allocation via pro-rata allocation receives a 1-lot allocation, if volume remains.
- Round 6: FIFO Allocation: Any volume remaining after top-leveling allocation is allocated via FIFO.”