A couple of days back, the WSJ ran a rather long article about the demise of the pork bellies contract at the CME Group's Chicago Mercantile Exchange (NASDAQ:CME). The story has an interesting historical angle, because about 50 years ago the bellies saved the Merc from its own demise.
In the 1950s, onions were the exchange’s lifeblood – its only really active contract – and onion trading was banned in 1958. The Merc leadership seized on pork bellies as a replacement, and the contract was introduced in 1961. It soon became a success, and likely saved the CME from oblivion. Given that the CME is now the world’s dominant futures exchange, and has been among the most innovative exchanges since the 1970s, the onion/pork belly saga is one of those contingent events that influenced the way the history of a major industry evolved.
It’s nice that the WSJ spilled some ink on the subject, but the economics in the article is something of a muddle. Or, perhaps, to be charitable to the writers, they are channeling some muddled thinking.
To wit, the article states that in the absence of an actively traded pork belly contract, market participants have no reliable information about prices:
For independent bacon processors, the decline of the pork-belly futures contract has meant that belly prices are becoming a mystery. The amount they pay for spot bellies is now based on a daily price quoted by the Agriculture Department, which collects it from producers on a voluntary basis.
So what’s the proposed solution? Cash settlement:
The CME and industry executives are trying to rejuvenate the pork-belly future. The exchange is looking at modifying some of the contract’s specifications, such as allowing traders to settle in cash instead of actual slabs of meat. Currently sellers, if holding a contract through expiration, must deliver 40,000 pounds of inspected frozen pork bellies with a producer certificate within 15 days, and a buyer must take possession. Another exchange idea: to trade fresh pork bellies instead of frozen ones.
“We are keen to change things as soon as we can,” said Tim Andriesen, managing director of commodity products at CME . . . . Changing the contract from physical settlement to cash settlement could help. Financial traders have largely shunned the contract because it requires buyers to take possession of massive quantities of meat.
“For a contract to be successful, you have to have fund participation” from hedge funds and commodity funds, said Dan Norcini, an independent livestock trader in Idaho who has been trading commodities for more than 20 years. “There’re not enough volumes for them to move in and move out.” Mr. Norcini stopped trading pork bellies about three years ago.
So, because of the lack of active futures trading there’s no good information about cash market prices, so the contract should be changed to cash settlement to rejuvenate futures trading. How does that work, exactly? The circularity is dizzying.
Whenever a contract exhibits problems, regardless of the cause, it is too often the case that the knee-jerk response is to call for cash settlement. (As another example, consider calls for cash settlement to fix perceived problems in wheat convergence.) Usually this response is completely irrelevant to the contract’s real problem.
Cash settlement works if there is an independent, reliable, relatively unmanipulable source of cash market prices that can be used to set a futures price at expiration. The markets for which these conditions prevail is very, very small. Cash settlement works in equities for contracts like the S&P500/eMini because there is an active, transparent cash market for stocks. It works pretty well for live hogs because the USDA collects data on the price paid for every animal bought by processors.
Beyond those examples, cash settlement is problematic, or in many cases, actually counterproductive. In the late-90s/early-00s, cash settlement in natural gas indexes was rife with misreporting and fraud. In 2008 I wrote a few posts about reports that banks were putting the lie in LIBOR.
Virtually no commodity market has enough active, transparent cash markets to support cash settlement. In grains and soybeans, cash prices reported by the USDA are bids and offers from country elevators, barge loading terminals, and processors. These aren’t bona fide cash transactions, and if these prices were used as the basis for futures settlement prices the temptation for the kind of monkey business that went on in natural gas in the Enron days would corrupt the grain business too.
Frequently the developments that create problems for a particular delivery-settled contract would create problems for cash settlement too. For instance, the decline in terminal grain markets – most notably Chicago – created problems for the Chicago-based delivery system for corn, wheat, and soybeans in the 1970s and 1980s. But the decline in terminal grain markets also meant that there were no longer vibrant centralized cash grain markets that could have been used to settle futures contracts.
In commodities in particular, the facts that futures markets are the locus of price discovery, and that market participants rely heavily on futures prices to set cash prices means that cash settlement is often problematic due to the circularity problem I mentioned earlier.
I would also note that, contrary to conventional wisdom, cash-settled contracts are not necessarily less vulnerable to market power manipulation that delivery-settled ones. As I showed in a 2000 JOB paper, it is always possible to design a delivery-settled contract that is less vulnerable to long market power manipulation than any given cash-settled contract, but this delivery-settled contract is more vulnerable to short market power manipulation.
Furthermore, the assertion that delivery creates headaches that financial players want to avoid should not be taken seriously. Financial players trade vast amounts of delivery-settled contracts in a wide variety of commodities, from aluminum to corn to crude to wheat to zinc. (Indeed, isn’t that what keeps Bart Chilton up nights?) They can – and do – liquidate/roll their positions before they need to make or take delivery. (Which is why Bart should sleep better.) The folks active in the delivery market are those who have the expertise and infrastructure to handle the physical commodity. And, ironically, some financial players are realizing that it can be quite profitable to develop that expertise and invest in that infrastructure for some commodities.
Finally, it should be recognized that delivery settlement has a compelling advantage. At delivery, people have to put their money where their mouths are. If they think futures prices at expiration deviate from cash market values, they can make or take delivery to take advantage of that perceived disparity. Delivery is a bona fide transaction, an exchange of the thing for money. Prices are intended to measure the terms of such transactions, and delivery – or the mere potential for delivery – ensures that happens. In contrast, with a few exceptions, with cash settlement it is often very, very difficult to collect data from such bona fide transactions, or to execute the trades necessary to exploit perceived divergences between cash values and futures prices (with stocks again being an exception).
It’s long been known that most futures contracts fail because underlying conditions prevent their viability. Frequently, these underlying conditions relate to industry structure (with vertical integration, for instance, being inimical to futures trading) and marketing practices. These conditions can evolve over time, making once thriving contracts no longer viable. That’s what’s happening in bellies, and cash settlement is not a magic formula that will change that.