Market Matters Blog
Pat Hill DTN Markets Editor

Wednesday 06/24/09
Index Funds and Wheat Convergence

It doesn't look as if a newly released Senate study on the woes of Chicago wheat futures is going to settle anything, as industry reaction is falling along pre-established lines.

Titled "Excessive Speculation in the Wheat Market," the report released by the Senate Permanent Subcommittee on Investigations places blame for the lack of convergence in wheat futures in the hands of index traders whose long-only positions, the report says, created excess demand for wheat futures, widening basis from an average of about 13 cents per bushel in 2005 to $1.53 in 2008. Index traders were able to exert such influence because the Commodity Futures Trading Commission eased limits on positions such traders could take, starting in 1991 and expanded in 2006. The exemptions allowed six index traders to hold up to nearly 130,000 wheat futures contracts at any one time; without those exemptions, they would have been limited to about 39,000 contracts, the report said.

The full report runs to 247 pages and incorporates a tutorial on futures trading, a history of markets, the advent of index speculation, futures market theory and the interaction of markets and crop insurance.

In its recommendations, the report calls on CFTC to phase out those exemptions, and it says it may also be necessary for CFTC to roll back position limits to the pre-2005 levels.

Industry reaction? Predictably, the CME Group was quick to disagree with the recommendations:

"CME Group applauds government efforts to ensure effective regulation of commodity futures markets. Nevertheless, we disagree with the findings and recommendations in the Subcommittee Report, which is based on anecdotal information versus sound empirical and economic analysis. The Subcommittee Report is contradicted by four separate studies conducted by The Commodity Futures Trading Commission ("CFTC"), the Government Accountability Office ("GAO"), Informa Economics Inc. ("Informa") and CME Group -- all of which concluded that there is no causality between market participation of index funds and non-commercial traders and wheat price levels or cash market convergence at expiration.

"The CFTC, the GAO, Informa, and CME Group, all used in-depth market data to analyze how changes in the positions of index funds and other market participants are related to price changes, as well as the price differential between wheat cash and futures prices. Each study concluded that fundamental supply and demand factors related to crop failures, strong economic growth in many importing nations, acreage switching caused by demand for bio-fuels, and currency volatility have all been responsible for recent periods of increased volatility and price swings in commodity markets. CME Group is committed to working with regulators and government officials to ensure the effective functioning of our markets, as well as the ability of all market users to access our markets on a non-discriminatory basis for bona fide investing and portfolio management purposes.

"CME Group, along with the CFTC and broader industry participants, have developed a number of steps to address convergence issues in the Wheat contract, including implementing seasonal storage rates, additional delivery territories, and reduced vomitoxin levels. These changes, which are being implemented beginning with the July 2009 contract, are expected to improve convergence between cash and futures prices."

The National Grain and Feed Association struck a middle ground between the committee report and the CME:

"The report of the Senate Permanent Subcommittee on Investigations provides an insightful appraisal of the declining performance of the CBOT wheat futures contract. The report reflects a view that has been expressed by the National Grain and Feed Association (NGFA) for several years: the CBOT market for wheat has fundamental problems and is not providing the kind of pricing and hedging performance needed to market grain efficiently and to provide forward-pricing contracts to producers that reflect the market.

"While the NGFA continues to review the details of the 247-page report, it concurs with the report's finding that the influx of capital from new players in the marketplace has contributed to the lack of convergence and placed financial stress on grain hedgers, particularly during periods of market volatility. This, in turn, has curtailed marketing options for producers as grain elevators and other grain purchasers have been forced to reduce offerings of forward cash contracts.

"The NGFA believes that phasing out existing hedge exemptions and so-called 'no-action' relief from speculative position limits for index funds and other investment capital is warranted and could enhance CBOT wheat futures contract performance. In this regard, the NGFA has conveyed its support to the Commodity Futures Trading Commission (CFTC) for a concept that would roll back the agency's 1991 'swaps policy' under which swap dealers have qualified for hedge exemptions. Specifically, the NGFA favors establishing a limited "risk-management exemption" under which swap dealers would need to apply to the CFTC and be approved for an exemption based upon the nature of their clients. Only 'commercial' business -- broadly defined as traditional, physical hedgers -- would qualify for the exemption. In addition, the NGFA supports phasing out -- over some reasonable time period -- 'no-action' relief granted to two index funds by the CFTC, under which they have exceeded speculative position limits."

And the National Association of Wheat Growers and the U.S. Wheat Associates released this response:

"The futures markets need to work effectively and fairly for producers and all participants in the market. The price discovery function of the futures markets are essential. The report clearly points out the magnitude of investment expansion by index funds in the market, and the convergence problems that developed at the same time. Speculators serve a vital role in the market but they cannot be allowed to interfere with the market's primary function of price discovery. The wheat industry is involved in this discussion -- Vince Peterson, USW's Vice President of Overseas Operations and a former grain trader is a member of a sub-committee advising the CFTC about the issue of convergence."

And from CFTC Chairman Gary Gensler: "Chairman Levin's thorough report is a significant contribution in understanding the potential effects of index trading in the wheat market, and other commodity futures markets. As the Commission continues our own analysis and appropriate regulatory responses, Chairman Levin's recommendations will be giving the utmost attention and careful consideration."
Posted at 1:07PM CDT 06/24/09
Comments (5)
The report is chocked full of holes in analysis, lacks objectivity, and appears to have been designed to reach a pre-determined conclusion to suit the bias of the Committee targeted only at speculators. For example, the concentration (relative to Open Interest) of index funds in the Cattle and Hogs markets were Higher than the concentration of index funds in Chicago wheat during that entire period yet we've never heard anybody allege excessive speculation or "high prices" in livestock markets as a result of index fund positions. Secondly, the value of wheat, like corn and soybeans, are deliverable in Chicago vs. a short futures position at option price instore. There is nothing in the summary of this report to explain why those controlling the delivery warehouse space in Chicago have, at times, set cash bids for SRW consistently at 100-150 under the nearby futures. Meanwhile, despite equally sizeable long positions held by index funds, the spread between cash bids for corn and beans in the delivery markets and nearby futures have remained quite reasonable. In fact, sometimes at premiums to delivery values. The Index funds don't set the cash value of grain in the delivery markets. The committee would serve the public's interest better if they were to call a few of the NGFA members to Public Hearings to justify why cash bids for ALL grains, especially wheat, in the delivery markets don't reflect the delivery values as guaranteed by the delivery process. Only Commercials operating in the delivery markets hold the key to unlocking answers to those questions. Indexers are out of the front month long positions well before delivery process occurs.
Posted by ken morrison at 3:00PM CDT 06/24/09
Thanks, Ken. Do you find it ironic that SRW average basis today is $1.02 under the July -- the narrowest it's been since early April, 2008? Lots of talk about the heavy presence of scab in this year's crop -- or is the threat of further regulation (and the changes CME made in delivery specifications) having some effect?
Posted by Pat Hill at 6:26PM CDT 06/24/09
Some of the past articles i have read indicates the index funds were banks. It would be transparent if the names of these index funds were made public. Since the fed and treasure have loaned money to banks I think the freedom of information act could be used to learn the names of these banks. larry plagman
Posted by Larry Plagman at 10:28PM CDT 06/24/09
Mr. Plagman, Most of the futures traded in the category of index funds are hedges against swaps underwritten by the largest broker-dealers (Goldman, JPMorgan, Morgan Stanley, etc) who guarantee certain returns to large pension fund investors. The swaps are typically of 2-3 year duration. The pension funds have put up the full notional amount of their investment which the banks use to margin their futures exposures. That's not to say there is not systemic risk to the financial system. For example, those pension funds who had swaps written with AIG starting pulling their investment when AIG got into trouble but, technically speaking, AIG was not using fed funds to support the index trading. In addition, the margin maoney AIG was required to deposit with the U.S. futures exchanges is held in a segregated account.
Posted by ken morrison at 1:01PM CDT 06/25/09
Isn't it rather nonproductive to debate why convergence didn't occur? For whatever reasons, over the last few years we've experienced serious variances from convergence. Faith in convergence among cash & futures market participants has been lost. Unless the futures contract is changed to force convergence, cash market buyers won't depend on it in the future, at least not for some time. If forced convergence is deemed desirable, modifying the futures contract to get it isn't a big challenge. There are several possible approaches. Probably the simplest would be to make individual delivery instruments deliverable only against during their initial delivery period.
Posted by Jeff Atkinson at 3:37PM CDT 07/15/09
Post a Blog Comment:
Your Comment:
Post Comment
DTN reserves the right to delete comments posted to any of our blogs and forums, for reasons including profanity, libel, irrelevant personal attacks and advertisements.