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Proposed Changes To Futures Trading

Texan

Well-known member
TSCRA Hears About Proposed
Changes To Futures Trading

By Colleen Schreiber

FORT WORTH — Four different proposals floating around in the halls of Congress could limit the effectiveness of the futures market as a risk management tool for the agriculture industry.

That was the message brought by Colin Woodall, NCBA’s vice president of government affairs, who addressed the marketing committee during the recent Texas and Southwestern Cattle Raisers Association annual meeting here.

“This financial crisis has everyone looking for someone to blame,” Woodall told listeners.

Because of the more egregious issues with swaps and derivatives, he said, the commodity exchanges were a natural place to lay blame. While it’s been determined that swaps and derivatives were part of the reason for the financial meltdown, they were not the only reason. The role of speculators, Woodall said, has also been looked into, particularly with respect to the run-up in oil and other commodities prior to the meltdown. Congressman Collin Peterson, D-MN, chairman of the House Ag Committee, has said publicly that speculators need to be reined in.

“We all know, though, that if we don’t have speculators, we don’t have an effective and efficient futures system,” commented Woodall. “Fortunately, we’ve been able to get Peterson to come off that so we don’t have restrictions on speculators like we did when this first started moving forward. It’s not an option for us to eliminate speculators.”

Blanche Lincoln, D-AR, chair of the Senate Ag committee and “a very good friend of the U.S. cattle industry,” also intends to take a hard look at this particular issue. Until recently the health care debate has kept her occupied, and now, because she’s up for reelection, she remains somewhat distracted. She’s also been distracted with cap and trade and more recently, as far as the ag committee goes, she’s been focused on childhood nutrition, which also has huge implications for the beef industry, Woodall noted.

“Still, we’re very encouraged that Senator Lincoln doesn’t just want to jump into this for the sake of doing something.”

Some in the cattle industry are concerned about the proposal to limit positions, and there is concern about continued liquidity in the futures markets. Woodall also said it is imperative that the Commodity Futures Trading Commission remain an independent body. However, he noted that some of the provisions in the House bills would have the CFTC setting the parameters and stipulations for the various contracts.

“We believe it should be the individuals working with industry that should be allowed to set these parameters,” Woodall told listeners.

Some of the House bills are also pushing to take away the core principles put in place by the exchange.

Margin position limits, for example, would be politicized and would have to go through a public hearing process. These core principles, Woodall insisted, are the reason the markets are so strong.

The chief lobbyist concluded his remarks by reiterating that NCBA’s primary focus on this particular issue is to make sure that CFTC remains the primary oversight body and that the industry plays a role in determining what’s best for the industry.

George Enloe, partner in Amarillo Brokerage Company, also spoke to the marketing committee.

“We are living in interesting times,” Enloe told the goup.

One of the biggest changes that has occurred over the last six years or so is the involvement of the investment community in the commodity markets. That involvement, he opined, has changed the markets dramatically, and in particular it’s impacted the hedgers. Enloe also told listeners that the makeup of their speculative trade has changed dramatically.

“Five to 10 years ago we had many customers who would speculate on the side. We have very little of that now, and I think the volatility has played a big part in that,” he commented. “The funds, however, have taken up the slack.”

Enloe offered a quick synopsis of the different types of funds. Basically, there are index funds and hedge funds, he explained, though the names are a bit misleading. Hedge funds, for example, really don’t hedge. Instead, they are more of a speculative investment type fund.

“They trade both sides of the market. If the trend is up, they’re likely to be buyers. If the trend is down, they’ll likely be sellers.”

Index funds, on the other hand, are basically an inflation bet.

“There is such a thing as a short index fund, but index funds primarily buy and hold. That’s part of what we saw in 2008. Not only were they growing pretty dramatically at the time, but they were buying commodities and holding.”

Just before Hurricane Katrina hit, he recalled, the cattle market was “pretty soft.” But because more people were invested in funds when the oil and natural gas went up due to the hurricane, all other commodities followed course.

“These funds accumulated more money from their positions increasing in value, and when that happens, they have to allocate that money to other commodities, and cattle rallied about $10 per hundredweight. It was the first time we had really seen all commodities move together to that extent.”

The cow-calf producer, Enloe said, really benefits from fund participation.

“When the funds are buying commodities, prices go up, and in turn, the cow-calf producer gets to sell his product at a higher price.”

However, what’s good for the goose isn’t always good for the gander. In this case, the guy who carries those cattle on to wheat or to the feedlot may be impacted adversely.

“The funds are a detriment to the cattle feeding industry because they are causing us to have to buy breakevens at a higher level than we otherwise would,” he opined. “We’ve basically been in that position now for about four years, and it’s largely due to this influx of money and to the futures market.”

Enloe told listeners that in the spring of 2008, index funds alone owned the equivalent of about 50 percent of the nation’s fed cattle supply, on paper, that is.

“Again, that’s good in some ways, but those guys only had to put up about $32 per head. At the time, when cattle were near their highs that year, if you were feeding, you had about $1200 per head in one animal. So it’s not quite a level playing field.”

When the cash market is above futures, that reflects optimism in the market, Enloe told listeners, “or it always has in the past.”

The premium in the futures to cash typically comes when there are expected tighter supplies down the road or some optimistic input into the market. When the futures are below cash, the thought is that numbers are going to grow or it could also indicate a traditionally weaker seasonal time or some other outside force that leads those in the market to be concerned about the future.

Enloe told listeners cattle feeders typically make the most money when the futures are discount to cash.

“It’s about an 80 percent correlation. So in other words, if the futures are above cash, you’re typically going to lose money, and when the futures are below cash, you’re going to make money. The reasons are, first, if the futures are below cash, you’re buying a breakeven below cash to start with, and number two, if we’re scared of the future, cattle feeders will probably put fewer pounds on those cattle.”

He pointed out again that for the last four years, most of the time the futures have been above cash, which has been a losing proposition for most cattle feeders.

During this time the funds continued to buy. He also noted that they’ve changed their strategy in the last couple of years.

“Used to, they kind of stayed in the near month and then rolled to the second month. Now they’re moving further and further out. They’re not only buying June cattle, they’re buying August, October, December, even out into 2011, so they’re encouraging the futures market; they’re making it inflationary. It’s not that they think cattle are going to be so high; it’s that they think all commodities are going up.”

Enloe presented several different charts during his presentation. One was a chart of crude oil, cattle and clean corn as well as the Goldman Commodities Index years 2006-2008. The Goldman Commodities Index Fund is a bundle of commodities, cattle included. The point of the chart was to show how these commodities all moved in unison during this time period, especially into the summer of 2008 and beyond.

“When they started down, they all went down together,” he reiterated. “I think a big part of that is these funds.”

Enloe also pointed out that open interest in live cattle futures has increased tremendously in recent years. One open interest means that someone has bought one contract and another has sold one contract. In 2005, open interest in live cattle futures was 130,000. As of about a month ago, it was close to 350,000 and that’s just the futures alone, not options. He pointed out, too, that since the first of February, open interest has increased by 70,000 contracts. He added that when outfits who control 60 to 70 percent of the open interest are all betting the same way, the market has no choice but to go that way.

“We’ve had this huge influx of investment into the live cattle futures market in the last couple of months, and the market has gone up,” Enloe said. “Admittedly, a lot of it is weather-related, but commodities overall have been strong.”

Speaking to the issue of proposed changes in regulation, specifically decreasing speculative position limits in futures, Enloe pointed out that as it stands, index funds are considered hedgers even though they are not typically producers or users of commodities, thus they’re basically not subject to speculative position limits.

“I know when I started in the commodity business, CFTC was always so concerned about several people getting together to influence prices, like when the Hunt family tried to corner the silver market in the early 1980s. The index funds aren’t necessarily getting together to make the market do something; they’re just doing the same thing, and they’re so big it has an effect on us,” he opined.

On the other hand, hedge funds are subject to spec position limits.

“Their position limits are so big,” commented Enloe. “They can own 5400 contracts in a month in cattle, so that’s almost 200,000 cattle in one month in one hedge fund. That’s equivalent to about three and four million head of fed cattle in the last seven to eight months. They really have as much or more control as anyone in the cattle business, and maybe all of us put together.”

He also pointed out that in this particular cattle market rally, hedge funds have been a bigger player than the index funds, and the hedge funds have actually increased their position much more than index funds.

“I’m a free market person, and our business is about free markets,” he added, “but I do feel like to an extent that the funds have been in charge of the hen house for the last several years. Futures traders and futures brokers have largely been self-regulated, meaning that the CME has been allowed to set speculative position limits.

“I’ve always been a big supporter of the CME, but now they own the Chicago Board of Trade, and in my opinion, they’re getting pretty close to a domestic monopoly. Before they were a public company, a lot of the guys who were in positions of authority at the CME were cattle traders, and they were in tune with the needs of the industry. However, as time has gone by, we’ve kind of become an afterthought, because we’re no longer the one giving them all the business.

“Now these index funds butter their bread,” he continued, “and so they’ve basically gotten anything they’ve asked for.”

A few years ago, they asked for increased daily trading limits to $3.

“It was changed from $1.50 to $3. Granted, it probably needed to be a little bigger because we have higher prices, but $3 was kind of a surprise, but that’s what the funds were lobbying for and that’s what they got.”

And while Enloe said his heart is first and foremost with the cattle industry, the crux of the matter is that the industry isn’t getting bigger. Thus, he pointed out, growth in open interest is most likely to come from those not involved in the industry.

Enloe concluded by telling listeners that minor changes to regulations are not likely to affect liquidity much.

“If they make a change that restricts the funds and kind of levels the playing field, I don’t see that as bad because I think we’ll still have plenty of liquidity,” he said. “Years ago, when our open interest was near 100,000, we didn’t have any trouble executing contracts, and in fact, I would say it was almost as easy to execute them then as it is today. A lot of these guys who are in the market, especially the index funds, buy and hold, so they’re not providing liquidity on a daily basis.

“At least for now, it’s working to our advantage,” he continued, “especially if you’re a cow-calf producer. Your position should be that you don’t want any changes to the futures contract and regulations. If you’re a cattle feeder you may feel a little different about that.”

He noted again that hedge funds are primarily trend-following funds, and right now the trend is up and up rather sharply.



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