Lean Hogs Jump- Computerized Trading Ruining Marketplace

Posted by Jeff Carter
on December 13th, 2010

The Lean Hogs futures at $CME jumped 157.5 points on one trade on the screen. At 9:15 am CT, the market was trading .7570, the next published trade was .7727. Just to let you know how much money that is, it’s $4 per one lot (or $4×170 points x1 conract=$680). If you look at time and sales, it shows that trades happened between the two prices. However, the move happened faster than one could blink an eye. (a limit up or down move in the hogs is 300 points from the previous day’s settlement)

In the time and sales data we pulled off CQG, the market traded .7672, next print is .7740 bid! Then the market doesn’t actually trade, but is bid and offered from .7740 to .7735, and the high is .7727.

We called CME GLOBEX and they said that it was a stop at .7570 and only 250 contracts traded. I was watching the market at the time, about to enter an order and saw it trade .7570 a couple of times. The CME GLOBEX explanation isn’t kosher with what was happening on the screen.

Meanwhile, in the actual pit there were resting orders above the market that didn’t get filled. The pit has a high of .7705. The only reason it went that high was arbitrageurs were able to sell the screen and buy the pit. If you were a hedger and had an order in the pit-you may or may not have gotten your hedge off. Order fillers and locals are shaking their heads. They used to make sure that the market was orderly.

This would never happen if there were actual human intervention in the market. The hog market at CME is broken, and I wouldn’t trade it if I were you. I would also avoid other thinly traded commodity markets. This is not the first time something like this has happened in electronically traded commodity futures markets. It is happening with more and more regularity.

The futures markets have embraced electronic trading. In general, it’s a good development. But applying the same solution to every futures market is not efficient. It’s akin to being a big government program. The CME is treating markets no different than a faceless government bureaucrat. Supposedly, private industry is supposed to be more flexible than that.

The hog market at the CME is broken and I would encourage people not to trade it. But, this is the same story that has happened across the board in many thinly traded commodity markets as they have transitioned to electronic trading.

Over at the $ICE, the coffee market and the cocoa market were destroyed by electronic trading. Traders have left the market. Hedgers are using privately negotiated contracts to hedge the crop. Volume has increased, but it’s merely high frequency traders pushing markets up and down. It’s no different in the ag markets at CME.

At $NYX European exchange LIFFE, the cocoa market has been manipulated by electronic trading. The problem is not too much speculation, the problem is the way the exchanges handle that speculation.

At NYMEX, the natural gas market is run up and down every day. At the CBOT, traders have had trouble in the more thinly traded grain markets. I know more traders leaving the marketplace than rushing to join. That’s odd given the big bull market in commodities.

The pure volume numbers on contracts look good. But looking at volume is missing the bigger picture. Exchange personnel slap themselves on the back over increased volume. But the only people that had anything to do with it were the tech staffs that increased the robustness of the systems.

Why do these markets exist? They exist so hedgers can manage their risk. The guy that has a coffee plantation or a hog farm can’t get the size off at any one price anymore. Many traders have left the market, leaving it to the electronic algo traders to make markets. Groups like Susquehanna have said they will no longer make a market in many out of the money option contracts because they get picked off continually.

A lot of the exchange management teams have little knowledge about what makes a marketplace. They have business degrees, but no practical experience in actual market participation. At CME, they never have had a focus group of actual traders in agricultural markets to solicit input. Management is not that much different than the actual person on the street, they have no idea why traders do what they do.

When I was on the CME Board at demutualization (2001), we worried about turning over a lot of functions to management. Management in its narrative upon going public (2003) pilloried the old membership, and distrusts it to this day. Management was supposed to hold regular focus group meetings with market participants to understand the market. This has never happened since CME became publicly traded.

Electronic trading in thinly traded commodities is a total bust. Markets like cocoa, coffee, hogs, cattle, oats, rice, and natural gas have been destroyed by electronic trading. The problem is that there is no actual volume on the bid/ask spread. This hurts hedgers. They pay more for their risk management. They are leaving the market. The volatility and moves are just too violent to use the listed futures markets as an efficient vehicle for hedging.

Killing the hedgers filters down into the real prices that the public pays for these commodities. Premiums go up, because of the increased cost to manage and hedge risk. Combine that with the artificial cost increase caused by Dodd-Frank and prices go up artificially. Prices don’t go up because of actual supply and demand market conditions. Try to lock in a natural gas price with your utility company and see how much of a premium you will pay.

Recall, hedging and risk management is why the contracts exist in the first place. In 1849, the CBOT wasn’t started so a bunch of people could make money. It was started so producers and suppliers could preserve their money.

Taking a look at seat prices, you see the evidence that the market is broken. The public looks at share prices of $CME, $ICE, and $NYX. But if you want to find out if people are really making money or not, check out the B share seat prices at CME, CBOT and NYMEX. Lease prices are also down significantly.

The CME B-1 membership was worth $1.2 Million last year. This year, the last trade is $532,000. Lease prices were over $2000/mo last year, now $1500. This is the real health of the participants in the market. CME management has ignored B share value. The reason for that is that CME management sees a trade off in value between the publicly traded A share, and the privately traded B share.

Is eliminating electronic trading the best solution to thinly traded commodity markets? In the very short term, it might be. In the long term there needs to be an actual hybrid solution brought to the market. The solution that CME now calls a hybrid is not a solution today. Instead, there are two separate marketplaces trading the exact same contract competing with each other. This is far different than a marketplace like the emini S+P.

The technology is there to transmit orders electronically to an open outcry pit, and have orders executed-and electronically reported back to customers. Meanwhile, the market gets the best of both worlds; the rationality of open outcry trading, plus the efficiency and speed of electronic trading.

If the exchanges don’t change, pretty soon there will be 20-30 traders controlling the entire publicly listed marketplace. Their marketplace will be irrelevant. The real market will be in the underground OTC market. Not a lot different than dark pools of liquidity and the stock market today.

UPDATE

I should add that every night when the large hedgers and big traders are in bed, computerized fund trading bids the hog market up every night. Usually from 2:30 am to 7am CT, the market rises .05 to .90 points. Doesn’t matter if the cash market is lower or not. This influences traders positions-even if at expiration the cash and futures merge. Markets can remain irrational longer than participants can remain solvent. In futures markets that is exacerbated because of margin.

For the record, CME management will say that I have sour grapes because I may or may have not lost money on this move. I didn’t make or lose money on it. I was in fact trying to enter an order to buy at .7570, but was only looking to scalp a few ticks out of the market. Not 150! As a trader, you get used to missing trades and markets. That’s not a big deal. Exchange managements have fallen down on their “caretaker of the marketplace function”. I also do not own a B share at CME, but do own A shares. I owned a B share from 1988-2010. If mgmt and others are ticked at me, fine-I also write a lot of positive stuff on CME too. Check the record. I also would invite people that agree or disagree with me not to email me, but leave your comments in the comment section. There are private listserves that traders may feel compelled to comment on, I would suggest you leave your comments here. The public needs to know.

UPDATE

over at seeking alpha, I was sent this.

welcome Silicon Investor readers.

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