HUNTIN' DAYLIGHT -- THE FUTURE OF CATTLE FUTURES

by: Wes Ishmael

“It is almost certain that finished cattle have put in their summer lows as prices have found support,” explained Andrew P. Griffith, agricultural economist at the University of Tennessee.

In his weekly market comments the first week of August, Griffith explained, “Based on seasonal prices, fed cattle prices increase an average of five to six percent from the summer low to the fall price peak. A five percent price increase would put finished cattle near $122 this fall. However, December live cattle futures are trading near $115, which insinuates lower prices from now until the end of the year. One truth about futures markets is that they are wrong. In this case, futures appear to be greatly undervaluing finished cattle in the fourth quarter.”

The notion that there is something busted in cattle futures has grown for a while. In fact, some would argue that Feeder Cattle futures are more of a liability than a solution in managing price risk these days.

“Feeder futures have become increasingly volatile in ways that often appear unrelated to market fundamentals,” explained Derrell Peel, Extension livestock marketing specialist at Oklahoma State University, in his early-May market comments. “Erratic futures price movements and increased basis volatility makes it difficult or impossible for the industry to use feeder futures for its two primary roles of risk management and price discovery.”

As Peel explained, marginal levels of liquidity continue to plague Feeder Cattle futures, which often limit the effectiveness of the contracts. In recent years, the source of liquidity changed, too.

“A growing proportion of the outside (non-hedging) liquidity in feeder futures is, by many accounts, from sources motivated primarily by portfolio management rather than actually speculating based on feeder cattle market fundamentals,” Peel explains. “Aided by computers and mechanical trading strategies, this type of activity tends to result in movements into and out of futures markets quickly and violently; resulting in increasing market volatility as underlying liquidity is exhausted….

“Perceptions are that the industry (feeder cattle producers and feedlots) are increasingly not willing or able to use feeder futures meaning that ‘non-fundamental' trading is responsible for more and larger price movements.”

Those mechanical trading strategies Peel mentions continue to be a source of bewilderment and mistrust, not just in futures markets.

Machines Trading With Machines

Although cattle futures traders were later coming to the proverbial party—electronic, high-frequency trading (HFT), based on algorithms, began to shape equities markets more than a decade ago.

In simple terms, with HFT, trade orders can be placed in a fraction of a second, exponentially faster than manual point-and-click traders. Right or wrong, algorithms determine when to buy and sell, and at lightening speed. Arguably, HFT traders most often represent the non-fundamental trade Peel mentions, folks in the business to mine trades rather than take a hold a position in the market.

At worst, some argue HFT and algorithmic trading is a recipe for markets being shoved in directions inconsistent with fundamental reality—creating a false market, so to speak—at such speed that true hedgers are unable to establish a position until it's too late. Never mind the fact that the available position may be useless for hedging.

According to the Congressional report, HFT Trading: Background, Concerns and Regulatory Developments, criticisms of HFT include allegations that the practice increases volatility and creates the illusion of more liquidity than exists. HFT is widely credited with contributing to the Dow Jones Flash Crash of 2010.

At best, the HFT wrinkle creates static and steepens the learning curve of folks unfamiliar with these systems, who are trying to use futures for their original intended purpose of offering opportunity to manage the price risk of commodities that will be delivered in the future.

Incidentally, CME Group (CME) found it was the manual, point-and-click traders that led market movements in Live Cattle futures on most of the limit-up and limit-down trading days (first few months of this year). That's according to a June Frequently Asked Questions document from CME called, CME Cattle Market Volatility.

CME Making Changes

Growing frustration with the effectiveness of cattle futures led to the National Cattlemen's Beef Association (NCBA) asking the CME to make some changes at the beginning of this year. That led to formation of an NCBA-CME Working Group, which is tackling the topic.

Between the first of the year and June, changes included:

• Reduced daily trading hours (Feb. 29) to align with the period of greatest liquidity. Roughly 87 percent of traded occurred between 8:30 a.m. and 1:30 pm CT last year, according to the CME FAQ.

• Added livestock products to its Messaging Efficiency Program (MEP) on Feb. 1. Without coasting too far into the weeds, a message is sent by buyers and sellers to submit, modify and cancel orders through the CME Group's electronic trading platform. The program monitors the ratio of messages to orders actually filled. Between January and April this year, the ratio of messages to orders filled in Live Cattle decreased by 15 percent, according to CME.

• Implemented a pre-open period for customers to enter, cancel and modify order for livestock futures and options.

The first part of August, CMW Group announced further changes, including:

• Seasonal Discount at Worthing, S.D. delivery location—CME Group will add a seasonal discount of $1.50/cwt. on live cattle tendered to its Worthing, S.D. delivery location for the October contract only. The new discount will be effective with the October 2017 contract, which will be listed for trading on Monday, August 22, 2016, pending CFTC review. The folks at CME say extensive research concluded this discount would better align delivery values with cash market prices and maintain compliance with CFTC's policy on location price differentials, while resulting in little or no impact on local cash cattle prices.

• Revised grading and quality specifications—CME Group will update par quality grades for both live and carcass-graded deliveries to 60 percent Choice and 40 percent Select, from 55 percent and 45 percent respectively. Pending regulatory reviews, these changes will be effective with the October 2017 contract month.

•Delayed listing of additional contracts—CME Group will delay listing any additional contract months beyond October 2017 as it continues working with the industry to evaluate ways to improve cash market transparency, review cash market developments and consider the introduction of cash-settled products if transparency does not improve. Only approximately 20 percent of cattle sales are negotiated in cash markets across the U.S. today with less than five percent in major producing states like Texas and Oklahoma.

In the meantime, speaking to Feeder Cattle futures, Peel explained, “Unfortunately, erratic futures markets have a very real impact on actual cash feeder markets with consequences that impact the entire industry and not only for direct users or potential users of the futures market.”

No one ever said there has to be a futures market for Feeder Cattle or Live Cattle. Far as that goes, no one ever said there has to be a cash market for them either. In both cases, though, so far no one has come up with a viable alternative.







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