WASHINGTON — Gary Gensler, chairman of the Commodity Futures Trading Commission, and representatives of grain-based food industries, the CME Group and the investment community testified July 21 before a Senate panel on "excessive speculation in the wheat market," presenting their views on what if any actions government should take to address the impact of index traders on the Chicago wheat contract.
The hearing was conducted by the permanent subcommittee on investigations of the Senate Committee on Homeland Security and Government Affairs. Senators Carl Levin of Michigan and Tom Coburn of Oklahoma, the subcommittee’s chairman and ranking minority member, respectively, officiated. Witnesses were asked to address findings contained in a 247-page report prepared by the subcommittee titled "Excessive Speculation in the Wheat Market." The report, which was issued in June, urged tight limits on index trader participation in the wheat market.
Mr. Gensler said the C.F.T.C. would consider seriously the committee’s recommendation it limit the positions of index traders to the standard speculative limits for wheat futures, or 6,500 contracts. Mr. Gensler also indicated the C.F.T.C. was reviewing the manner in which the agency previously issued exemptions from position limits, which allowed select index traders to greatly exceed the position limits applying to other users of the Chicago wheat contract.
The C.F.T.C. itself will conduct hearings beginning July 28 that will examinethe imposition of federal position limits in futures markets for physical commodities where such limits currently do not exist, unlike the agricultural markets. Mr. Gensler told the senators the hearings also will consider whether the "bona fide" hedge exemption should continue to apply to persons using a futures market to hedge risks other than risks arising from the actual use of a commodity, as in the case of index traders’ use of the Chicago wheat contract.
Mr. Gensler said index trader activity in the Chicago wheat futures market was a contributing factor to lack of convergence seen in that contract in recent years, but there were other factors, including contract design and the large carry that recently have characterized the Chicago wheat futures market.
Mr. Gensler noted recent efforts of the CME Group to improve convergence in the wheat contract. Last December, the CME Group added several new delivery points and raised storage fees applicable to delivery certificates effective with the July 2009 future, and effective with the September 2009 contract, the CME Group lowered the amount of vomitoxin permissible in wheat delivered under the contract.
"With these changes, however, we saw only small numbers of deliveries at the new locations and still a significant lack of convergence as the July contract expired," Mr. Gensler said. "We will watch closely for the full effects of the changes in the September delivery period." He suggested the exchange consider other adjustments to the contract, including the possibility for cash settlement.
The third factor contributing to the lack of convergence was persistent wide spreads between futures contracts usually associated with periods of ample supplies, Mr. Gensler said. A market at full carry, where it remains profitable for traders to keep grain in storage because the commodity’s value as expressed in the higher price of the deferred future exceeds the full cost of financing, insurance and storage, "may expose weaknesses in the delivery mechanism of a contract," Mr. Gensler said.
"Traders seeking to take advantage of full carry markets can at times overwhelm the capacity of grain delivery facilities," he noted.
At the same time, Mr. Gensler acknowledged, "Observers are divided about whether the large carry has been a cause of the lack of convergence, or a symptom of it."
Hayden Wands, director of procurement, Sara Lee Corp., Downers Grove, Ill., and chairman of the commodity and agricultural policy committee of the American Bakers Association, said bakers appreciated the efforts of the CME Group to address convergence problems with the wheat contract through increasing barge rates and adding delivery points.
"However, these actions are directed toward the symptoms rather than the root problem," Mr. Wands said.
The root problem was the recent increased and essentially "unrestricted" participation of index funds that "artificially amplified the price of agricultural commodities, including wheat, in 2008, and this continues today," Mr. Wands asserted. "Physical users of the commodity compete with asset-holding investment groups who operate with no limits to the amount of wheat they can purchase, unlike traditional market speculators. Due to the index funds’ ‘buy and hold’ strategy, volatility has greatly increased, adding undue financial risk to farmers and end users, including bakers.
"A.B.A. strongly believes that index funds must operate within the confines of a contract limit similar to the limits that traditional speculators have efficiently operated under for many years."
Tom Coyle, general manager, Chicago & Illinois River Marketing L.L.C., Chicago, and chairman of the National Grain and Feed Association, told the senators the grain industry agreed investment capital in the Chicago wheat contract played a significant role in driving futures values to artificially high levels that threatened the contract’s viability and undermined the "bedrock fundamental principle" of convergence upon which grain hedgers rely.
"We believe that this situation, in which a large portion of the crop is not for sale at any price for extended periods, has sucked liquidity out of the contract and contributed to extreme volatility," Mr. Coyle said.
At the same time, Mr. Coyle said the N.G.F.A.’s preference was for the problem of convergence in the Chicago wheat market to be addressed through further constructive changes to the contract with minimal government intervention. He pointed to a "promising" concept developed and being studied by the CME Group that would implement variable storage rates at grain elevators approved as delivery locations. He also made reference to the N.G.F.A.’s modified compelled load-out concept that would work to restore convergence and that the organization referred to the CME Group for consideration.
But if constructive changes to the contract do not succeed in restoring convergence, other measures might be necessary, including revamping how the C.F.T.C. establishes hedge exemptions, including setting a potentially tighter regulatory standard for hedge exemption eligibility, Mr. Coyle said.
"We would not want to see markets legislated or regulated so firmly as to remove producers’ and hedgers’ opportunities for favorable returns in a well functioning marketplace," Mr. Coyle testified. "The challenge is to find the right combination of changes to contract terms and appropriate public policies that will ensure the Chicago Board of Trade wheat futures contract serves its original purpose: to provide price discovery and risk management to traditional users."
Charles P. Carey, vice-chairman, CME Group, Inc., Chicago, testified the CME Group shared the subcommittee’s concern that the lack of convergence impairs the value of the Chicago wheat contract and must be corrected, but he asserted there was no evidence to support the conclusion index funds were the principal cause of the lack of convergence.
"We are concerned that the (subcommittee) report’s focus of blame on index traders and speculators directs attention away from appropriate efforts to identify any structural problems with the contract specifications and impairs our ongoing efforts to cure the problem by fixing those terms," he said.
Mr. Carey pointed to recent changes to the Chicago wheat contract and indicated the CME Group hoped they would result in a significant improvement in convergence as early as mid-September and certainly by the end of the year.
"If the results fail to meet our expectations, we have additional modifications at the ready and are prepared to continue to modify the contract or introduce a new contract to provide a safe and effective environment to permit producers and users to hedge their needs and to provide effective price discovery to the remainder of the market," he said.
Mr. Carey’s views were supported by the testimony given by Steven H. Strongin, managing director, Goldman, Sachs & Co.
"We do not think that passive index investors have been responsible for excessive price volatility in the wheat market," Mr. Strongin said. "We base this conclusion on the analysis of other commodity markets without passive investments or similar economic exposures."
The failure of the wheat contract to converge with the cash market was driven by the design of the delivery mechanism of the futures contract and should be addressed by making the necessary adjustments to the contract, Mr. Strongin said.
"Finally, we think that implementing position limits, ceasing to allow position limit exemptions or eliminating index investing altogether will not reduce the volatility of prices in the wheat market but may have unintended consequences," Mr. Strongin said. "For example, index investors based outside the U.S. may move their activity offshore, or the proposals that are currently being debated may simply splinter the positions held by index investors, in the process potentially increasing market volatility."
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