Pork Bellies are Bacon

The Wall Street Journal has an article on Pork Bellies today. I know a little about Pork Bellies. I have traded Lean Hogs for the latter half of my career.  The Pork Belly contract made the $CME.  The CBOT was always the big boy in town.  The CME was a puny Butter and Egg exchange.  CME tried trading other contracts, onions for example.  There was so much abuse in the trade that they banned trading in onions in 1958.  The Belly contract was started in 1961.

Some background, pork bellies are the raw meat from a hog that is turned into bacon. Currently, the belly is receiving some fame on plates in higher end restaurants. Asians have loved pork belly for centuries. It has made the jump across the Pacific to the US. Pork Belly prepared correctly is a delectable mouth watering treat.

If you want to follow the daily price of bellies, look here.  These are the voluntarily reported prices to the USDA.  Soon, we will have mandatory price reporting which should provide better cash price information to the market.  Yesterday, the price of bellies was .9423, unchanged from the day before.

Among traders of a certain era, the belly contract is legendary.  Many fortunes were made in that pit.  The price of bellies is extremely volatile.  In its day, the belly pit was like the S+P futures pit.  Huge intraday moves up and down which offered plenty of opportunities to scalp the market.  The success of the belly contract attracted traders.  This pumped up seat prices at the CME.  Success leadled to the innovative culture at CME.  The belly contract leadled to development of Live Hogs, Live Cattle, and eventually to the financial futures contracts that the CME used to become an international marketplace. CME would not be where it is today without the bellies. (sorry about the typos)

When I started at the CME, I was a runner for Stotler and Company next to the belly pit.  The pit was a virtual zoo, and it was full of characters.  There was more drama in that pit than a soap opera on TV. The question is why did it all end?

There are several reasons for the contracts demise.

The pit itself shares some of the blame. Some brokers and locals saw the amount of profit that could be made out of trading against order flow and continuously ripped off customers.  It’s not unlike a lot of the HFT and algo programming that takes place today.  Sniffing, quote stuffing, orders that seek other big orders, flash quoting.  HFT firms running the stops.  Wall Street has seen trading volumes drop because of the nefarious activity that remains unchecked and codified by the SEC, CFTC and exchanges today.  The retail customer lost confidence in the bellies, and they have lost confidence in the stock market.  The deck was and is stacked against them.  Retail people never get a fair shake anymore, and are the personal pigeons of the market place.

The CME also bears some of the blame.  Markets evolve.  The CME stuck with a belly contract that was invented for 1961.  It is a frozen contract.  The industry moved to fresh bellies, and hence the frozen contract lost a lot of its meaning.  Instead of listing another contract, or changing the existing one, CME sat on its hands.  After being so innovative, CME lost its ability to think out of the box.  The bellies also never made the jump to the computer screen when the contract was healthier.  To take a dead contract and put it on a screen is not doing anything at all.

Then there is the industry itself.  In 1961, there were lots of meatpackers, lots of farmers, and lots of producers.  The industry was fragmented up and down the supply chain.  Today, the industry is more vertically integrated.  The market doesn’t have to use a publicly listed contract to manage its risk.  It uses privately negotiated OTC contracts instead.  Counter party risk is less of a concern, so the CME clearing house is not needed.  The industry changed dramatically, and the contract didn’t adapt.

As the pit started its demise, trading talent left for greener pastures. Some belly traders went and tried their hand at financial futures. Others went to more actively traded agricultural markets. This loss of human capital was bad for the market. There are still plenty of old belly traders that walk the floors of CME. They don’t like to see the end of belly futures anymore than anyone else.

Commodity funds that became a big presence in the commodity futures markets at the turn of the century (2000) never traded the bellies. It was not because it was a deliverable commodity. Funds trade oil, cattle, grains, softs which are all deliverable. It was because there wasn’t any volume in the first place. Funds have to be able to get out of positions. They were guaranteed losers if they traded bellies.

However, the industry is still better off with a good, tradable public market.  These two lines from the article leave a clue,

“For independent bacon processors, the decline of the pork-belly futures contract has meant that belly prices are becoming a mystery. The amount they pay for spot bellies is now based on a daily price quoted by the Agriculture Department, which collects it from producers on a voluntary basis.

This year, spot prices have soared 45% from June to an all-time high of $1.60 a pound in September, before tumbling back to a low of 88 cents by late October. Now they fetch around 96 cents. “It’s getting completely out of whack,” said Chris Kunzler, president of Kunzler & Co., a Lancaster, Pa., bacon processor.

Bellies are going the way of onions.  Onion prices are more volatile than oil prices. It’s time to rethink the belly contract. It’s also time to start trading futures contracts in more things, not less. Price discovery and consumers will benefit.

The unwillingness of the SEC, CFTC and exchanges to correctly regulate and manage the electronic marketplace makes starting new contracts almost impossible.  There cannot be a healthy marketplace without some retail trade.  Retail traders are taking their money out of the marketplace.  Eventually, markets will collapse upon themselves.  The only participants left will be the handful of HFT traders that survive.  Just like the lone trader in the pork belly pit.

Chatted with longtime belly trader. Here is what he had to say. The current belly contract doesn’t match the needs of the market. The different bacon processors (slicers) want different standards. Currently, the contract calls for skin on (like the above photo), frozen. That’s not what the processors use.

There are other problems. Processors and producers try to hide the price that they pay and sell the product for. There will be mandatory price reporting in the cash market, but it remains to be seen if that will help in price transparency. Depends on those standards.

There are a lot of bellies in the freezer. 55 million pounds. Since the demise of the belly contract, bacon price has fluctuated wildly, forcing the entire chain of distribution to assume more risk. This means higher prices. Ironically, it’s not because of speculators. Open interest in the belly contract, along with volume are non existent. I hope Bart Chilton is watching.

The world needs to come together on this. Entities need to hedge. If they can’t, the consumer will pay.

welcome Wall Street Journal readers

tip of the hat to Eschatonblog

Thanks for the tweet and mention Felix Salmon

Welcome Instapundit readers

tip of the hat to Respublica

25 thoughts on “Pork Bellies are Bacon

  1. Jeff,

    Why is it that whenever you mention high frequency trading you are bashing it? All that high frequency shops are doing is using resources that are available to everyone you is willing to pay for them to trade in a more effective manner. What, in your mind, is the problem with that?

    1. My problem is the playing field is uneven on the futures side, and the SEC side is so whored up. I have no particular problem with HFT per se. But, regular electronic traders aren’t quote stuffing etc. They also don’t get the advantage of co-location, even though they pay the same for a membership and commission.

      1. Jeff,

        None of the practices you vilify high frequency traders for (quote stuffing, stop hunting, etc) are illegal are they? I know the answer to this, it’s not. You know the rules of the game and are aware of some of the tactics being used to gain a short term edge in the markets. I think it would be more productive for you and your readers if you spent more time talking about how to overcome the half a tick they may be giving up to high frequency traders (which is less than they were giving up under the open outcry system).

        Also, co-location is available to anyone who would like to pay for it. Firms and people buy or lease memberships for the discounted rates. Co-location is a separate issue.

        1. neither was cornering a market, but they made that illegal. The exchanges, and the regulators are so far behind the curve that they are consistently playing catch up. In a pit there was peer pressure to keep a trader honest. No such thing on a screen.

          In lightly traded markets, HFT has destroyed the bid/ask spread. Look at cocoa, coffee, hogs. Nothing there. Especially when a 250 lot stop moves the market like it did the other day.

          Nothing against HFT in a computerized environment, but we ought to level the playing field to make it competitive.

          On the SEC side, the structure of the market has been so fragmented, price discovery doesn’t work. We need to start with good regulation, then let every one play.

          1. Right, they made it illegal. If regulators choose to change the rules then HFTs will have to adjust their strategies. One thing is for certain, they will adjust, they won’t just sit back and say “before these new regulations we were making a killing”.

            You say that in certain markets HFT has destroyed the bid/ask spread. How so? Do you think it’s too wide? Too thin? What are you basing that on?

            The fact that seems to be escaping you is that there is in fact a level playing field. The rules are the same for everyone. However, not everyone can play the game at the same level. If I want to play one-on-one with Lebron James should he have to play blindfolded just so the game is competitive?

            It’s fine to say that there should be more regulation but that is a very broad statement. What sort of regulations would you like to see put in place to curb what you see as the negative side effects of HFT?

          2. In previously thinly traded markets, there is no longer size on the bid/ask spread. there is more slippage in price on larger orders. Bigger traders have left the market. Spreaders are blown out of positions because of very volatile moves. didn’t used to happen. I know plenty of hog traders that used to carry between 200-1000 spreads, that barely trade 50-100 now.

            tough in a comments section to specify all regulations. But, if you know markets, a 250 lot should never move the market like it did. We wouldn’t have flash crashes.

            We disagree on what makes a level playing field.

          3. You’re fighting a losing battle talking sense to Michael. His mind is made up, confusing him with facts will not change that.

          4. You’re fighting a losing battle talking sense to Michael. His mind is made up, confusing him with facts will not change that.

          5. I’m sorry. I must have missed these facts that you are speaking of Henk. Please point one of them out to me

          6. You’re fighting a losing battle talking sense to Michael. His mind is made up, confusing him with facts will not change that.

          7. You’re fighting a losing battle talking sense to Michael. His mind is made up, confusing him with facts will not change that.

          8. You’re fighting a losing battle talking sense to Michael. His mind is made up, confusing him with facts will not change that.

          9. Jeff,

            I have never traded hogs electronically or in the pit so I won’t give an opinion on the composition of the order book. I do trade other thinly traded products and I can say without question that the quality of my hedges has improved in the last few years. This is something I actually measure, I’m not guessing. Fill quality was much worse when I had to call a desk, have my order walked to a pit, then sometimes have to wait hours to get a fill. Are there irregularities every now and then? Sure there are but the people (HFTs) who are either benefiting or suffering as a result of those irregularities are playing a different game than you or I so why should you care. You missed out on an irregular move in the hogs and some people probably got stopped out of trades they would not normally have been stopped out of. What about the fact that most markets are one tick wide and a couple of contracts on each side of the bid ask? That saves everyone a tick or more everytime they enter or exit the market. That benefit outweighs the cost of rare volatility spikes in my opinion.

            As far as a level playing field is concerned, there is nothing to disagree about. Either it exists or it doesn’t. My understanding of a level playing field is that one exists when everyone has to play by the same rules. It does not mean that everyone will be successful. We all know the rules and we can all write code, co-locate, etc if we have the resources and the desire.

            It’s your blog so I’ll give you the last word if you decide to respond.

    1. speculators don’t want consumers to pay more or less. they don’t care. they want a transparent market with a level playing field.

      Problem with the bellies is that the cash market is muddled, and the current contract doesn’t match what the slicers want.

  2. “This pumped up seat prices at the CME. Success lead to the innovative culture at CME. The belly contract lead to development of Live Hogs, Live Cattle, and eventually to the financial futures contracts that the CME used to become an international marketplace. CME would not be where it is today without the bellies.”

    lead -> led

    Success led to the innovative culture at CME.

    The belly contract led to development of LIve Hogs, ….

  3. Very interesting post. Thank you for all the market micro-structure color.

    As you lay out, this pork belly contract you mention is mostly being abandoned by antiquated design and poor market making. One major difference with the onions contracts is that the onion contracts were banned in 1958 (like the movie contracts this year) by congress. I believe the relevant statute was the Commodity Exchange Act.

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