Live cattle futures began trading in 1964 on the Chicago Mercantile Exchange (CME) as a non-storable commodity futures product. At the time, most fed cattle traded in the river market stockyards of Chicago, Kansas City and St. Joe.
The contract was established as a delivery product and as feeding of cattle spread to the plains, additional stockyards were established as delivery points. Only shorts were allowed delivery options to provide a mechanism for forcing convergence of cash and futures at the termination of a contract month.
The cattle futures, like other futures products, are a risk transfer vehicle following the model of grains in the ag sector. Early traders in cattle contracts were mainly composed of commercials (hedgers seeking to lock in a profit margin) and speculators (interested in guessing future prices for cattle).
Later day participants in cattle futures are index funds, technical traders, and flash traders and other computerized algorithms to initiate orders.
The core participants in cattle futures trading are the commercials. They are always around and always interested in protecting pricing. They include a mixed bag of interest ranging from:
• Supermarkets—These are longs wanting to fix future prices for beef;
• Food service—These include restaurants, and fast food companies who also are long hedgers;
• Processors—They can be long or short but are protecting processing margins or either cattle they buy from producers or beef they sell to retailers;
• Exporters—These are global participants who can be either long or short depending on whether they are buying or selling; and
• Cattle feeders—These are mainly short hedgers using the appropriate out month for locking prices.
The sometimes participants are parties who find it advantageous to enter the market but can disappear on whim.
• Index funds—These funds offer inflation protection to corporations. They purchase (long) a basket of commodities in order to deliver to buyers of their fund protection against a rapid rise in inflation rates in the country;
• Managed futures funds—These are speculators who jump in and out of the market at whim and can be either long on short. They might use technical or computerized trading programs;
• Individual speculators—They can be day traders to big picture long-term traders who develop their own theory of prices for the market on the long or short side; and
• Hedge funds—They can enter the market on either side and may be macro investors or simply protecting exposure they have in another related market.
A well-functioning futures market serves all the interests of the participants both functionally and fairly. This doesn’t mean they all profit from trading, but it does mean the design of the contract is properly constructed to present fairness and equal opportunity to all traders in a manner that fulfills their market objectives.
The current live cattle contract fails to provide functionality or fairness. The contract construction was for a stockyard marketplace that existed in the 1960s where all cattle traded on a live basis. That marketplace no longer exists.
Trade supporters of the delivery contract argue for hours about market specs such as weight parameters, quality grades and “out cattle” on deliveries that should never happen. Animal rights activists have questioned all unnecessary stress to livestock, and delivery to antiquated stockyard facilities is riddled with problems not even considering the unnecessary cost burdening a delivery system. The live delivery is not even reflective of how cattle are mostly traded with two thirds sold on a dressed basis with a grid.
The contract also fails to provide fairness. Longs cannot call in a delivery. Only shorts can deliver. This basic fact prevents longs from entering the market. A hedge fund operator in Darien, CT does not want to receive 10 loads of cattle in Clovis, NM.
Many of the large feeding companies don’t want to end the delivery advantage given them in the contract’s construction and have prevailed with CME officials in sustaining a delivery contract. The advantage is a mirage. It doesn’t exist and destroys liquidity—the heart’s blood of a futures contract.
The current discrepancy between cash and futures is not as simple as computerized trading as the culprit. There are computerized trades tied to the stock market but understanding the index funds is very important to understanding the market.
The index funds are owned by large corporations hoping to find protection from inflation in the fund. In obvious times of recession, those corporations will sell the index fund, having no need for inflation protection. In turn, the index fund must liquidate commodity positions including cattle in order to fund the exiting corporation. These are forced orders forcing large volumes of short trades on the cattle contracts.
The industry’s failure to change the contract is now coming back to haunt them. They have lost the longs in the marketplace. Futures prices are $40 under current cash for summer month or $500/head. Feeder cattle purchases start a feeding venture with $150 losses at best. The longs have disappeared from the market.
The answer to a dysfunctional cattle contract is a cash settlement contract that includes all negotiated grid cattle, and all formula cattle, converted to a live price FOB the feedyard. These cattle, after adjusting them to the proper week, and including cash market sales, will provide a reliable, transparent cash settlement price that will return the longs to the market and provide the liquidity necessary for any functioning futures market. — AgCenter
