In practice, financial markets often operate very differently from how they should operate according to investment theory. Markets are supposed to discover prices freely through a process of transparent bids, offers and price settlement mediated by neutral exchanges. For example, according to Investopedia, the Efficient Market Hypothesis posits that equity “shares reflect all information” and “stocks trade at their fair market value on exchanges.” However, the increasing frequency of flash crashes, minutes long but with huge price volatility swings, e.g., in the automated trading of foreign exchange contracts, has led to the automation of “kill switches.” During periods of extreme price volatility, when excessive financial speculation distorts fundamental price-related information, rumor runs riot and traders dump their contract positions, the “free” market needs a sheriff to restore the exchange’s reputation as the home of fair market value.
So, in practice, kill switches — computer programs that temporarily stop or reduce trading when free market theory breaks down — can help to stabilize market prices and participation. Furthermore, introduction of a kill switch may also attract more investors and increase the share price of the exchange’s own index products, as NASDAQ’s simultaneous introduction in 2013 of a kill switch and two new indices showed.
One way to reduce the need for kill switches and the unwanted publicity they bring about excessive speculation is for exchanges to increase their up and down price limits. No need to throw the kill switch, per the exchanges’ rules, if the limits have expanded enough. In late April, the Chicago Mercantile Exchange (CME) Group announced that effective May 2, it was increasing the daily up down limits on its grain, soy and lumber futures contracts. For example, in the case of corn, the most traded grain futures contract, the up down limit jumped by 50% over the previous limit, to 40 cents/bushel up and 40 cents/bushel down per trading session. A CME fact sheet explained that the price limits are reset in May and December. According to the CME methodology, “Expanded price limits are approximately 50 percent higher than daily price limits and remain in place until no futures contracts settle at limit.” At that point, price limits are reset again on the contract.
The market welcomed the new price limits by increasing the May 3 futures corn price to $7/bushel for the July 2021 contract on the Chicago Board of Trade (CBOT), a CME subsidiary, before settling at $6.82/bushel at the end of the May 3 trading session. While that may not seem like much of a price swing on $7 corn, the price was $3.26/bushel on September 30, 2020, two weeks before the three Republican member majority of Commodity Futures Trading Commission (CFTC) voted to greatly increase speculative position limits levels.
In March, Reuters cited a note from a commodity broker to his clients: "The expectation is that higher position limits will lead to higher volatility, with perhaps higher highs and lower lows in the months ahead." The same article noted that commodity index funds (CIFs) have been driving the prices higher. Under the new position limit rule, the CIF positions are not counted towards position limits. This is not to say that an increase in China’s corn imports and a drought-related decrease in corn exports from Brazil have not been factors increasing current corn futures prices 142% since May 2020. Rather it is to suggest that the financial and agricultural press are wrong to report the price increase entirely in terms of supply and demand factors.
The new position limit rule gives the exchanges near total discretion in determining which contract positions would count towards aggregating limits levels. IATP’s summary of the 10-year battle over the rule cited Commissioner Dan Berkovitz’s dissent: “the proposed rule demoted the Commission from head coach to Monday-morning quarterback. The Final Rule declares that the players on the field are the referees. In this arena, the public interest loses.” What is the public interest? Part of the public interest is knowing when and how much excessive speculation in one or more contracts is harming the interests of everyone who produces, processes or transports a commodity, collectively “commercial hedgers.” Consumers too are impacted by raw materials prices of consumer goods inflated by speculation.
Historically, it was possible to understand the categories of market participants in a contract by consulting the CFTC’s weekly Commitment of Traders (CoT) reports. For example, a July 2008 study by Michael Master and Adam White interpreted CoT data to show how index speculators were driving food and energy prices higher and to dangerous levels of volatility. The study helped to trigger congressional investigations and testimony that eventually resulted in Title 7 of the Dodd Frank Wall Street Reform and Consumer Financial Protection Act of 2010. Better Markets used CoT data to argue for position limits on index speculation in a 2011 comment letter and subsequent letters to the CFTC. However, the new position limit rule gave the exchanges, such as the CBOT, so much discretion on whether to report speculator positions that the CoT reports make no sense of the current composition of market participants and how their contract positions are affecting futures prices.
The current “super cycle” in commodity index trading includes agricultural derivatives contracts, although the biggest part of the boom is in oil and industrial metals contracts. Central banks, above all the U.S. Federal Reserve, continue to make credit available at historically low interest rates, fueling both the stock market and commodity derivatives boom. The Bloomberg Commodity Index is at its highest price since 2015.
However, the CoT numbers are not consistent with the investor categories that are driving prices in the Bloomberg index or any other. The CoT reports the volume of open interest in a contract at the end of a trading session, i.e., the contracts for which buyers and sellers have not agreed on a settled price. The CoT classifies traders and whether they are buying contracts to “go long” in a contract (for prices to increase) or to “go short” (for prices to decrease). For example, consider the CoT report on futures only report for April 27 on the CBOT yellow corn contract.
To judge by the “Percentage of Open Interest for Each Category of Trader,” you might think that the contract was serving the interests of commercial participants, as required by the Commodity Exchange Act. About 25% of the “Producer/Processor/Merchant/User” category invested in the CBOT corn contract to go long, while about 70% invested short, consistent with those commercial participants who are trying to drive down the raw materials costs of feed, starch and other uses of corn. How could “swaps dealers” and “managed money,” the main classes of index dealer brokers (as well as being themselves investors), be the prime cause for the price increase and volatility of the yellow corn futures contract, while their open interest was much less than that of commercial hedgers?
There are two main answers: 1) under the new position limit rule, the largely self-regulated exchanges can determine which positions to report and have decided that most swap dealer and managed money positions don’t have to be reported to the CoT; 2) the swap dealer and managed money automated trading systems, currently unregulated by the CFTC, close out their positions before the end of the trading session and therefore are not reportable as open interest. The intraday price volatility is driven by the hyper-speed execution of one trading algorithm to another. The CME Group is creating a price volatility index that monitors volatility in all asset classes, not just stocks. Soon you’ll be able to invest in that index, to drive volatility up or down, just as you can invest in the stock price volatility index now.
Don’t farmers benefit when financial speculators drive prices above the cost of production? Usually not. According to an October 2020 study by the USDA Economic Research Service (ERS), based on 2016 data, just 47,000 of more than two million U.S. farmers used futures and options contracts to manage price risks, largely in corn and soy contracts. About 10% of all corn and soy farmers used futures and options contracts, according to the ERS authors. However, as prices become more volatile and the likelihood of trade loss greater, exchanges demand that farmers and other commercial price hedgers put down a larger amount of margin collateral to make bids and offers on the contracts. Commercial hedgers, especially those without access to super-computers, are unable to place timely bids in the world of near speed of light trading.
The U.S. Department of Justice has begun to investigate the traders of physical commodities for common, if complex, crimes, such as bribery. However, the now seven-month old position limit rule, while enabling huge daily and intraday price swings that can be traded long and short at great profit, has not triggered new CFTC investigations. The White House has yet to nominate a new chair for the CFTC, and the Commission is deadlocked with two Republican and two Democratic commissioners. Without a new chair, the CFTC staff are unlikely to analyze how the exchange’s de facto self-regulation of the futures, options and Over the Counter (off exchange trading) markets in physical commodity derivatives is serving the price risk management needs of commercial hedgers.
Instead, the CFTC issued an advisory on April 6 that warned the public about the dangers for individual investors of speculating in the futures and options markets based on trading tips on social media. But such an advisory, however much it serves the public interest, cannot prevent the harm to commercial hedgers of extreme price volatility and legalized excessive speculation allowed by the self-regulation of exchanges. In 2012, the late Commissioner Bart Chilton remarked, “High-frequency ‘cheetah’ traders should be registered with regulators. The [high-frequency trading] programs need to be tested before they go live, and they need kill switches to stop them if they go feral. And, if somebody causes a market anomaly with a runaway cheetah, they need to be held accountable. In this new algorithmic-driven trading world, we need to re-think how we assess penalties: fines for bad conduct in millisecond trading should be assessed on a ‘per second’ basis. So, yes, markets continue to evolve. Their oversight needs to also.”
But the CFTC has yet to finalize a rule on how to regulate automated trading, including high-frequency trading, much less regulate the design and use of kill switches. Furthermore, a robust rule and scalable fines should apply not just to the “cheetah” traders but to the exchanges whose self-regulation allows the cheetah trading programs to go feral. The CME announced on May 4 that it would close most of its “open outcry” (human to human) trading pits, including those for agricultural contracts, permanently. The end of an era should mark the start of a new round in the near decade long struggle to regulate automated trading and the excessive speculation enabled by exchange self-regulation.
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