While extreme volatility and the threat of bank-busting margin calls is receiving much of the attention for today’s commodity market problems, lack of convergence is also a sticking point, according to farm leaders.
Convergence is the idea that by the close of the contract futures, prices eventually equate to the cash market. It varies by commodity and geography, but historically the relationship between the cash and futures markets has been fairly constant with predictable seasonal variation.
Tom Coyle with the National Grain and Feed Association, speaking at a Commodity Futures Trading Commission agricultural forum, said consistent and reliable convergence between futures and cash prices, “is one of the bedrock fundamentals on which hedging strategies are predicated.
“Today, that previously reliable relationship between cash and futures has deteriorated to a point where many commercial grain hedgers are questioning the effectiveness of hedging using exchange-traded futures.”
Coyle noted that genuine convergence is occurring less often and only for short periods of time. He says the band of convergence has widened due to several factors, including higher and more volatile transportation costs, demand for storage created by biofuels growth and the futures market running ahead of cash values due to passively managed, long-only investment capital.
Bob Stallman, president of the American Farm Bureau Federation, noted, “Today neither the convergence of futures to cash nor reasonable expectations of basis levels applies for a number of contracts. This is significantly increasing the risk faced by producers and will likely induce major structural change in the grain/oilseed/fiber handling sector over the next few months.”
Stallman said the problem is compounded by the fact many producers are being asked to make firm price commitments for inputs. “In some instances, they are even being asked to pre-pay for inputs they will not use until next crop year. This results in the uncomfortable position of producers locking in future input costs without similar opportunities in future crop prices.
Stallman suggested these possible solutions to the convergence problem:
• Require additional delivery points to prevent market manipulation and assure an adequate delivery system. “The Kansas City Board of Trade is currently in the process of increasing its wheat contract delivery points from two to four. We would encourage other exchanges to consider similar changes.”
• End the certificate of delivery and return to the notice process originally used for delivery against the futures contract. “This should not cause any major disruption to futures trading. Once the change is made and traders realize delivery means actual physical acceptance of the commodity or that there will be some monetary penalty for re-tender, then we should see the orderly liquidation of open interest going into a contract delivery period and a more orderly convergence.”
• Cash settlement. “The volume for cash-settled grain and oilseed contracts today is probably too small to test in practice. Moving to cash settlement should not be undertaken lightly, but it should be studied as a way to improve convergence.”
• A moratorium on all hedge exemptions for passively-managed, long-only investment capital entering agricultural futures markets. “For funds already approved for hedge exemptions, the NGFA strongly recommends against expansion of hedge exemptions beyond levels already approved by the CFTC.”
• All passively-managed, long-only investment capital should participate in futures on a dollar-for-dollar, un-leveraged basis, with all investment capital fully margined.
• Assure that all long-only, passively-managed investment capital entering agricultural futures markets is correctly reported to the CFTC and properly categorized and reported to help provide clarity for market participants.
• Poll the grain handling industry immediately to determine accurate commercial storage values. If warranted under current conditions, implement those rates, with CFTC approval, for corn, soybean and wheat contracts as soon as possible to enhance cash/futures convergence.
• The NGFA generally supports the concept of exchange-cleared swaps as a mechanism that creates the opportunity to spur innovation and new risk management products.
• The NGFA is supportive of repealing restrictive CFTC regulations on agricultural trade options (ATO). In their place, the NGFA supports rules allowing commercial participants (elevators, producers, processors) to engage in ATOs in the course of their businesses.
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