CME Cattle Futures- Still a Legitimate Risk Transference Vehicle?

By The Beef guest blogger, Gary Lark

One of the outstanding men to hold the office of President of the United States was Theodore Roosevelt. A president that many westerners and cattle people can relate to. Roosevelt famously worked for a “fair deal” for all Americans and a level playing field in this capitalist nation. In his time, this did not make him universally liked.

This week an organization that sees itself as representatives of bedrock Americans, cattlemen, are holding their annual meeting in San Diego. A hot topic is the cattle futures market and its transformation since becoming an all-electronic trading platform. Specifically the perceived domination of the daily price movement by automatic trading programs and what many associate with it, historic inter-day volatility not connected to related outside shocks such as mad-cow disease.

Inter-day price swings have resulted in basis shifts as great at $9 per cwt in a “flash.” No human is driving these rapid price swings based on fundamental or technical indicators. Even the savviest young tech weaned on video games cannot click a mouse as fast as the market is moving.

A letter to the CME from the NCBA broaches the topic of the impact of automated trading programs on the cattle futures market. The letter in part states, “…In fact, we continue to hear our members question their use of the cattle contracts because the volatility has made them a tool which is more of a liability than a benefit. This is counter to the very existence of these contracts…”

I go back to the days before the Commodity Futures Trading Commission (CFTC) replaced the Commodity Exchange Authority (CEA). Then the “not-for-profit” commodity exchanges had to appear before that commission on a regular basis to justify that the contracts being traded provided a risk transference service to the underlying industry. Without justification as a legitimate vehicle to transfer inherent risk in the underlying industry to individuals willing to take on this risk, the futures trade would be nothing but vehicles by which to gamble. It is being argued that the way the market is now structured, it adds risk and serves a community of high speed traders and “for profit” CME Inc. over the interests of the cattle and beef industry. This conversation strikes at the regulatory heart of this issue, legitimacy.

I recently had a conversation with someone who represents the large High Frequency Trading (HFT) firms. He categorically said that the large HFT’s do not trade cattle futures because it is not an active or deep enough market. Yet year old CFTC data has been quoted to say that 32.4 per cent of the daily volume in livestock futures (Live Cattle, Feeder Cattle and Lean Hogs) is a result of automated trading programs. My guess, for a number of reasons, is that this number is greater than 32.4 per cent in Live Cattle and that this aggregate number is brought down by Live Hogs and especially Feeder Cattle. This lobbyist suggested that “some guy in his basement” might have written a trading program that is active in the cattle futures market. There is a large middle ground between the large HFT firms and “some guy in his basement.” The volume of contracts traded everyday by automated programs, if not generated by either, are generated by mid-size firms who are happy with the returns gleaned from the cattle market. This conversation said to me that even if large HFTs are not active in cattle futures they have a dog in this fight and their financial might will be brought to defend against any threat to automated trading.

The automated trading programs are often benignly compared to the pit scalpers. A major difference is that the pit scalpers never ran the market, being reined in by the order fillers and the pit community. Pit scalpers had losing days, were bound to one location and other aspects of the human condition.

The issue at hand this week at the NCBA convention is not about global commodity trading or necessarily about getting rid of automated trading programs. It’s about the cattle futures contract and the impact of automated trading on this specific contract. When the CME conceived the cattle contract it was a revolutionary concept. Cattle are perishable, non-storable and without a carry. Contract specifications have always been a moving target and delivery-forced convergence has been a constant source of argument and conflict. The deliverable supply at any point would never justify the daily volume and position limits required to make it a “bread and butter” contract to the present day CME, like it was at one time. This is partly why the major HFTs might actually not trade it. Now, it is a relatively small contributor to the overall CME volume and therefore to the massive growth of executive compensation that has occurred since becoming a public corporation.

The cattle contract is fairly unique in the world of commodity futures. One could even call it a “special needs” contract. This is why for years I spoke out against the CME’s one-size fits all approach. The electronic platform tends to focus volume on the two front months and works well for large internationally traded markets. However, the 23 hour trading day was detrimental to cattle futures and the current “close” at 1:00 followed by three more hours of trading is not adding to the quality of the trade. Commercials were able to find bids and offers of size in the back months from trader/spreaders in the pit. This is no longer available and does not serve an industry that needs to price 6 months or more into the future.

There is some irony in the migration from the pit to “the screen” in an industry full of home-spun wisdom. Cattle people have often stated, “if it ain’t broke, don’t fix it.” The cattle contract was not broke as a pit traded commodity, but now that it is “fixed up” on the electronic trading platform it is being called “broke.”

The community of members who traded in the pits were often individuals very invested in the preservation of the institution they belonged to and the markets they traded in. It is lost that many people who traded in the cattle pit also fed cattle and were devoted to making sure the customers they represented got a “fair deal.”

And this brings us back to President Roosevelt. The issue at hand is not an, ‘us versus them’ issue. It is about some core values and a level playing field. A “fair deal” for everyone who wants to or needs to use cattle futures to hedge or take on the risk being laid off by the commercials. There are those of the latter who are abandoning a perceived un-level field to the algorithms. If the NCBA is right, then many more are eyeing the exits. Logic would dictate that the CME will have a cattle contract that is ‘algo vs algo’ until there is no meat left on the bone.

Automated trading programs generate the volume the CME needs to enhance profits. They have the money to influence regulation through politics. The CME has firmly defended their one size fits all approach. The voices of those that used to be in and around the pits that supported the cattle contract are dismissed as self-interested dinosaurs. They do not have the influence among the regulators or the politicians. If there is any chance that change will come to cattle futures, it will be through combined support behind this effort by the NCBA and others in the cattle and beef industry, for they connect the futures contract with the historic legal justification for existence.

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