The National Cattlemen Say Markets Are Broken

Here is a letter from the National Cattlemen’s Beef Association to the CME.   The reason I post it is not to indict CME.  I post it because it is indicative of a lot of markets.  The cattle market is significantly smaller than the E-mini market, or the Treasury market.

 January 13, 2016

Mr. Terrence A. Duffy
Executive Chairman & President
CME Group
20 South Wacker Drive
Chicago, IL 60606

Dear Mr. Duffy:

For several months we have been hearing from our members across the country regarding market volatility and their concerns about high frequency trading’s contribution to that volatility. The concern has been so intense that the National Cattlemen’s Beef Association (NCBA) hosted a meeting with our members in December to further explore their concerns and to identify ways to address the issues. During that meeting we heard from industry traders, economists, and hedgers who delivered evidence and first-hand accounts to support the shared concerns.

Exchanges such as the ones owned and operated by the CME Group have their basis in agriculture. For years, agricultural producers have utilized futures contracts to manage their market risk. The effectiveness of cattle futures contracts as a viable risk management tool is being called into question due to the concerns over high frequency trading. In fact, we continue to hear our members question their use of the cattle contracts because the volatility has made them a tool which is more of a liability than a benefit. This is counter to the very existence of these contracts. These concerns have been focal points during the meetings of state cattlemen’s associations over the past several months, and many of the suggested actions have been drastic. In order to stem the tide and maintain producer faith in CME Group risk management tools, NCBA has taken it upon itself to identify critical areas in which we direct your focus. In anticipation of your presentation at NCBA’s Cattle Marketing and International Trade Committee meeting in San Diego later this month, we look forward to comments or action on the following:

1. Livestock contracts must be monitored, measured, and controlled through the CME Globex Messaging Efficiency Program. Grain, currency, and index contracts have limits regarding messaging. Livestock contracts must have the same.

2. A one second latency or delay between trade actions (cancel, cancel/replace, etc.) is imperative to make automatic trading work. Implementing latency will make messaging much more difficult as there will be greater risk of order execution. High frequency trading occurs at a rate faster than any human can analyze. Latency would therefore level the playing field so that everyone sees the market at the same speed.

3. The CME Group has to be more proactive regarding spoofing. Identifying spoofing concerns and bringing them to light, rather than waiting until they are reported, would go a long way in showing stakeholders your commitment to addressing this issue.

4. In order to better analyze and understand market action, the CME Group must release audit trail data for analysis that includes firm-level generic identification. This would be utilized by industry and researchers to better understand trading behavior which could possibly be damaging. Release of the previous year’s data each month should be acceptable in providing researchers with adequate information while also protecting the confidentiality of traders.

5. As a self-regulated organization, CME Group has the responsibility of regulating and policing any misuse of futures contracts. There are concerns that the CME Group bases most of its investigations from tips or concerns brought forth from those who use the contracts. The CME Group has to actively engage in monitoring and acting upon violations or market manipulation. More importantly, CME Group should be vocal in reporting these actions to stakeholders.

These are actions which we believe will be effective in showing CME Group’s commitment to addressing our concerns, and it will provide our members the confidence to continue utilizing CME Group livestock futures contracts as a risk management tool. NCBA is committed to working directly with you and your team to find a solution to the concerns our members have, but quick action towards a solution is expected.

Sincerely,

Philip Ellis                              Ed Greiman
NCBA President                     Chairman – NCBA Cattle Marketing &
                                                    International Trade Committee

If you talk to old cattle traders, they will tell you that their market is broken.  Hog traders have echoed their sentiments.  This isn’t sour grapes over losing the floor.  It’s about customers like the members of the NCBA that cannot get into and out of large positions when they need to roll contracts without getting run over.  The risk of hedging in the plain vanilla futures market is too great.  It used to be cheaper to hedge there, but now it is probably cheaper to execute an OTC derivative.  However, doing that comes with counter party risk and other costs.   The other alternative is to go unhedged.

For consumers, it will mean higher meat prices.  If producers and packers have to figure out ways to internalize risk, they will pass it along to consumers.

I am not going to wade into the debate over electronic trading vs open outcry. Open outcry had its peccadilloes too. I want to make some different points about electronic trading.

I am also not indicting the whole HFT community.  Like the old floor, there are good guys and there are a few bad apples.  They are just trying to make money like anyone else.  They didn’t build the system-they just play in it.

The floor community used to monitor open outcry. There was peer pressure. there was an organized Pit Committee process.  Pit Committee people took that job seriously.  That process cannot exist with electronic trading and only the exchange can monitor the community.

The other point I want to make is that when electronic trading started, there was an emphasis on one statistic over all others, trades per second.  TPS was touted by exchanges to show the robustness of their electronic platform.  In the late 1990’s, Eurex and LIFFE were way ahead of CME.  Their TPS was double CME’s.

TPS is a specious statistic.  Going faster shouldn’t have been the most powerful force behind electronic markets.  It forced all kinds of bad decisions later.  The real reason electronic markets were powerful is the open access to order flow that it gave every market participant.  Everyone could be on the top step.  Speed doesn’t necessarily create efficiency.

I remember that all of us focused on speed at the outset of electronic trading.  It came up in the board room.  It was talked about on the floor.  Equity owners that had a financial stake in the game wanted us to go faster.  Traders at the CBOT would tell us they partnered with Eurex because their system was faster.  Traders are hyper competitive people and beating the other exchanges was on our minds.  We made a mistake.

Nobel Prize winning Professor Alvin Roth has stated clearly that financial (and futures) markets are too fast.  Read his book on Who Gets What and Why.  The faster they go, the more distortion there is in price.  Competition is not on price, but on speed.  Supply and demand curves adjust on price, not speed.  The market is actually less efficient in academic terms the faster it goes.  At the same time, the market was inefficient at slow speeds too.

There is an entire business in the electronic trading world that strives to cut latency.  This is the time it takes electronic messaging to make a round turn in the pipes.  CME and other exchanges have developed a very nice business selling co-location to traders.  They have created their own “top step” and sold it to some entities.  Using Professor Roth’s theories would end that business.

It would be interesting to see how markets behaved if exchanges slowed them down.  Suppose they matched trades at one second intervals.  That would cure a lot of the spoofing because anyone that put up a big order would be on the hook.   They wouldn’t be able to cancel it before getting hit.

Slowing markets down would also give humans a chance to interact with the market right alongside computers.  Instead of competing on speed, which humans are guaranteed to lose, they would compete on price which changes the risk dynamics of trading.

My gut tells me we would see thicker books, and less marginal volatility.  Retail investors and hedgers would be able to get into and out of positions.  Professional traders would be able to build larger positions again.  That would be good for markets, but it would hurt the profitability for one segment of the industry.  It would probably hurt the share price of exchanges too.  But, they’d be doing what they are supposed to be doing; providing a level playing field for people to manage risk and raise capital.