The Chicago Board of Trade (CBOT) was founded on April 3, 1848, by 83 merchants at 101 South Water Street in, believe it or not, Chicago! Its purpose was officially stated to be:
"To maintain a Commercial Exchange; to promote uniformity in the customs and usages of merchants; to inculcate the principles of justice and equity in trade; to facilitate the speedy adjustment of business disputes; to acquire and to disseminate valuable and economic information; and generally to secure to its members the benefit of cooperation in the furtherance of their legitimate pursuits.”
Boil that all down and it means there are two purposes of the CBOT:
1) Price discovery of the various commodities of a standardized grade.
2) Opportunity to transfer the risk of price change.
The price of a commodity is discovered at a futures exchange the old fashioned way: by bid and offer, aka an auction.
As commodities became internationally traded through exports and imports, the CBOT has come to represent the “world price” of a given commodity.
There was a lot of price risk associated with growing and owning commodities in 1848 and even more now. Some folks can afford the risk of price change and some folks cannot afford the risk of price change.
There are people who welcome the risk of price change in exchange for the opportunity to make a profit on price change. These folks are called “speculators”. Speculators do not grow a commodity; they do not own a commodity and have no intention of ever owning or using a commodity. Speculator simply want to make a profit from the change of the price of a given commodity. The vast majority of futures traders are speculators, perhaps 95%.
The people who do not want the risk of price change who trade at a futures exchange are “hedgers”. A “hedge” is an investment tool to reduce the risk of adverse price movement of an asset.
If a grain merchandiser owns a million bushels of soybeans, he usually does not want the risk of price change on that million bushels of soybeans. The CBOT provides the opportunity for that merchandiser to pass-off that risk to speculators who want to speculate on the price change of soybeans. A grain merchandiser makes his money on blending and “merchandising” the grain, not speculating on the price change!
If a merchandiser wanted to make money on the speculation of price change, he would never own the physical commodity where he has to invest the full market value of the grain to own it. He could “leverage” his investment money by trading futures for about 6% of the cash value of the grain at the CBOT instead of 100% of the cash value of the grain in the cash market.
Speculators provide a valuable service to those who grow, merchandise and consume grain.
Can you imagine calling your grain merchandiser at your local elevator and tell him you want to forward contract 20,000 bushels of soybeans and he says he will have to find a buyer in the cash market before he can accept your offer to sell? That is what he would say if there was not a futures market for grain. Speculators form a pool of ready, willing and able buyers at the CBOT for those 20,000 bushels of soybeans for which you want to lock-in a price.
Hedgers generally have a larger position (more open contracts) than the speculators, but a hedger’s trades may be weeks, months or even more than year from the time he opens a position and offsets that position. A speculator holds an open position for as short a time as a few minutes, a few hours, days or weeks, maybe even a few months, but seldom longer than a few months.
The ability to transfer the risk of price change is taken for granted because we have had that ability all our lives. But, without the ability to transfer that risk of price change, chaos in the grain markets would be the result and it would be ugly, very ugly. The result would be similar to what happened to the economy in Venezuela the past twenty years or in Russia after the Soviet Union collapse. Absolute chaos would rein.
The two days after the terrorist attacks on September 11th, 2001, the CBOT did not trade and it was chaos for the grain industry.
Although the CBOT did trade in the days after Jimmy Carter announced on January 4th, 1980 a grain export embargo to the Soviet Union (our biggest corn buyer in 1979), there was virtually no one willing to place a buy order. It was chaos because there was no way to determine the market price of corn, wheat and beans for several days. You have to have a buyer and seller to set a price!
Hedgers need speculators and speculators need hedgers. Although the relationship is discussed and often cussed, it is, none-the less, a symbiotic relationship.
What keeps the futures market honest is the ability to give or take delivery of the actual commodity on a futures contract. That requires the futures price to come to the cash price during the month of delivery.
December 2021 corn futures contracts can be settled with corn bushels any business day in December 2021. If the futures are too low, a corn user will buy a December futures contract and require the physical bushels be delivered. If December corn futures are above the cash price, owners of physical bushels of corn will sell a December futures contract and deliver their corn to fulfill their delivery obligation. If the cash price and futures price of corn are aligned, the futures contracts will be offset with an equal, but opposite transaction in December 2021 futures, negating the financial incentive for anyone to deliver or accept delivery of the commodity.
I say again, the CBOT futures market is the world price as determined by world supply and demand. Basis is the measure of local supply and demand. The two will never be near the top of their annual price range on the same day. Thus, you will make more profit by separating the day you lock-in the basis from the day you lock-in the futures.
All futures exchanges in the USA are regulated by the Commodity Futures Trading Commission (CFTC) whereas all grain buyers are regulated by each State’s Department of Agriculture.
There are grain futures exchanges around the world. The Dalian Commodity Exchange is the prominent futures Exchange in China. It was established in 1993. The Rosario Board of Trade in Rosario, Argentina is the prominent futures exchange in South America. It was founded in 1884,
There are more than one hundred futures exchanges worldwide.
Comments