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.


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 think it’s also important because populist fervor in America today wants to jail bankers.  America is a capitalist society.  Free markets that work are important to our societal survival.  Otherwise, socialist and centralized bureaucracies will exert too much control over markets and they will fail continuously.

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.



  • KIR

    I could write 1000 pages on this article. First, the letter to Chairman Duffy is accurate and well stated. The problems faced by legitimate hedgers are vast and nuanced. Yet, they all have the same cause. And, they all came about for the same reason. The cause is the demutualization of the exchange. This shifted the paradigm from one that served the customer to one that ignored the customer to serve the shareholder.

    When this happened, one statistic was revered like a deity. It became the end all, be all. That stat is Volume. The exchange was obsessed by volume. Employees were compensated for increasing volume. Revenue and shareholder value relied upon growing volume. They even went so far as to intentionally mislead the trading public by positing that greater volume meant increased liquidity. That would be like saying homeowners would be better served if multiple real estate brokers should be paid to better facilitate transactions between the home’s buyer and seller. It’s bullshit.

    In order to grow volume in markets that are limited by size of the underlying physical commodity, the exchange had to woo new participants into the market. They offered them everything under the sun to get them to trade agricultural products. Put bluntly, they changed the rules and policy so that these new players were guaranteed to make money. All, they had to do was spend the most on technology. This hurts market liquidity and integrity for a few reasons. The first and most obvious is the issue of risk. Because they get first right of refusal on all orders, HFTs never have to take their foot off first base before the other one is firmly planted on second. This is not sour grapes that the big boys are able to make tons of money. It is pointing out that the current system undercuts the primary reason that futures exchanges were created. To transfer risk! When no risk is taken, no service is provided.

    The second is the expense and ubiquity of these HFT prop shops. People lie when they tell you that electronic trading is less expensive. When I started trading, my overhead was a Bic pin (pilfered from Burlington Bank if I recall) and a deck of trading cards. Now, to be competitive in the race to Zero, trading firms must spend millions, if not tens of millions, to have a shot at seeing bids and offers before they’ve already been traded against. When your overhead is a pen and paper, you’re happy to make 5 grand a day by capturing the edge on opening and closing orders. When your nut is six or 7 figures, you have to steal a ton of money to cover those expenses. The customer orders are getting hosed. Because they need to be to pay for this new arms race. Even worse is that one system can be employed over every single product listed on a given exchange. Sure, there were lots of bad eggs. We can all name guys who took no risk, provided no service, and made a career out of bagging trades. But, these miscreants were limited by geography, time, and space. They could only bag orders with the brokers who were in the length of their arms and their voice. Now, a particularly unethical computer program can front run and steal every customer order in every market. This is why trading rights are worth so much less than they once were. Sure, a yellow badge allowed you to trade in any pit. But, you had to walk into that pit. And, you can only stand in one pit at once.

    These problems have a simple cause and a simple solution. The cause was the manner in which electronic markets were created. Electronic markets were not engineered to replicate open outcry. Emphasizing the structures which worked and eliminating its weakness and inefficiencies. Instead, they were engineered to do one thing. INCREASE VOLUME. Accommodate as much volume as possible in as little time as possible. Transactions mean money. Revenue means shareholder value. So, they tried and succeeded in building a platform that could accommodate millions of transactions per second. Too bad, markets don’t run like a factory.

    The reason electronic markets have gone so far off course, without attempting to replicate the time tested, proven positive market structures we had in the pit is because electronic markets never had to compete with the pit. Electronic markets did not come about because they competed against and defeated open outcry. Not even close. They were shoved down the throat of customers. Settlements were uilaterally moved to the screen from the pit. Market Reg no longer regulated behavior which hurt the customer. They penalized behavior that made the pit viable. They basically fined people for making pit trades. It was intentional, unethical, and widespread. I can tell you from personal experience that CME’s Director of Market Reg spent years and hundreds of thousands of dollars prosecuting me because I made markets in the pit that were more competitive than those available on the screen.

    They had a mandate to kill the floor and switch to electronic trading. And, they bullied and intimidated anyone who tried bringing value to the floor. In no way am I saying that open outcry is superior to electronic trading. But, I can say with absolute conviction that electronic trading in its current form is vastly inferior to Open Outcry. The reason is because it never had to compete with open outcry.

    What is the answer? You’re on the right track. Things need to be slowed down. After all, every customer order should be auctioned off to a community of risk taking, market making, self financed, independent traders. It is impossible to hold a fair,competitive auction in a nano second. Imagine if you were selling a painting through Sotheby’s. And the auction ended before the curtain had even been lifted. That’s what is happening to customer orders. We don’t need to create speed bumps and circuit breakers. We had the best circuit breakers in the world. Our brains and our eyes. Markets never moved faster than the human brain could register and react to what its eyes were seeing. Go back to humans clicking mouses. Problem solved. If you want to get technical, then go to a system of batch trading.

    Then reduce the hours. Greater hours means more exposure for the real risk takers and more opportunity for exploitation by the real front running scum bags.

    I’ve got the capital, the connections,and the resources to make all of this happen. But, I’m tired of dealing with the rampant incompetence, negligence, and corruption that pervades Market Regulation. Our exchange ceased being a Self Regulated Organization the day Dean Payton took over those operations. SRO means traders regulating traders. Now, we have hired thugs trying cases before a kangaroo court. No oversight. No justice. Just a bunch of mediocre lawyers, who’ve never seen a floor, never made a trade, who are paid to collect more in fines than they take in for salary. The morons on BCC are bought and paid for. If they do not vote for the largest penalty, they are not invited back. They do not care about customer harm. They are a censorship board paid to manufacture cases to silence anyone who dares to speak the truth.

  • J. Walsh

    Great post, Jeff.
    @disqus_c4f6pnJcM4:disqus- keep fighting!

  • boxtor

    I’m not sure a 1 second delay would be sufficient. A random delay (0.5-1.5 seconds?) might be more beneficial. It’s harder to game or defeat than a static 1 second delay.

    • That is an interesting idea. One that I have no idea about how to engineer. It would have to be randomized, so that algos couldn’t pattern recognition.

      • boxtor

        One way that would introduce latency without requiring physical latency would be an earliest revocation time.

        If you submit an order at t0, you cannot cancel it until the time t0+r, where r is some random small duration. r would need to be calculated by the market (where you post an order) and would likely need to use high quality random numbers.

        This would give a time duration of r where their order could be hit. Since their is a much higher likely hood of it, they would need to determine whether it’s worth the risk or not.

        This approach wouldn’t completely negate the benefit of co-location (keep the earliest response time as close to t0+r as possible) and CME could still make money from it.

  • HMO

    what you stated , is frankly what needs to happen to level the playing field and return the markets to their original purpose…risk transference rather than exchange profitability ………….unfortunately anything which affects shareholder value in a negative way …? …..well , that just won’t happen internally….perhaps its time for an outside force to become involved in this cause ? Just a thought

    • It would be great if it was easier to startup a competing exchange. But the CFTC (and SEC) make that cost prohibitive given the risk/reward. Startup costs are a minimum of $2-5M.

    • KIR

      Agree. A return to risk transference and level playing fields may stagnate volume. But, it is the only way any exchange will survive in the long term. And consistent volume only means less shareholder value because the current business model is so dependent on transaction fees for revenue. Alternate revenue sources need to be explored. If an exchange has to issue more fines and trade more contracts year after year to sustain itself, then for profit exchanges are all unsustainable.

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  • toadstool

    It is hard to add too much to these insightful comments. They address serious issues for those who are engaged and rely on the Livestock Futures Markets. I pre-date the CFTC to the CEA years. The livestock contracts are not “natural” contracts since they are perishable and not internationally traded, storable commodities. At their inception they were ground-breaking contracts with doubtful viability. The Live Cattle contract for a long time was the flagship of the Exchange The CME spent years and money convincing the underlying industries to use these contracts to transfer risk. They eventually prevailed. The not-for-profit commodity exchanges had to justify their existence
    in service to an underlying industry as a viable risk-transference
    vehicle. If one were to apply strict standards, that test may not be passed. Now these same contracts may be on their way to becoming virtually unusable by the
    industries that they were created to serve. When basis risk is greater
    than flat price risk, migration away will gradually take place.

    Years ago, I suggested that the efforts to make these contracts viable on Globex be stopped when volume on both platforms reached a level of parity. One reason is that the commercial users relied on back month traders and spreaders to provide a bid and ask on size to be able to move either long or short hedges. This required that a human trading community be allowed to be sustained along side an electronic platform. Electronic markets focus on concentrated volume and in most markets this is limited to the front two months. There are now no visible bids and offers of size beyond the front months. This is only one example of why the “one size fits all” approach by the CME is wrong-headed and may ultimately lead to the demise of the livestock futures contracts. There are numerous others.

    Some practical business issues were pointed out in these comments. The notion that something meaningful can or will be done is implied by the fact that problems are being brought up. It is noted that the for profit CME is focused on and dependent on volume. I would encourage everyone to think about something more mundane than how volume contributes to share-holder equity. When the CME was a successful institution providing useful risk transference tools that served underlying industries and a broad base of speculative interests the top executives earned approximately 500K per year for their responsibilities. With executives now earning multiple millions per year in addition to the “perks” and corporate status that are seen as part of the job. CME Inc is now a volume addict. Those in the executive suite cannot maintain their gravy train without the volume. It is not about the quality of trade, but the quantity of trade. I would like to think that appealing to these top decision makers to “do what is right” for the livestock contracts would result in constructive action, but I fear human instincts (greed/entitlement?) will not allow this. I have witnessed the demise of many contracts during my tenure. Some are gone because of short sighted decision making. My bet would be that statistics will be brought out to justify business as usual and that the powers that be will deny, then suffer the demise of these relatively minor contracts rather than make changes that could in theory hurt volume in the short run and executive compensation.

    • To be fair, if CME didn’t demutualize it wouldn’t exist. But, I agree, a one size fits all approach to trading different markets doesn’t work either. Hogs and Cattle were very different than grains, even though they were agricultural.

      At the same time, because everyone focused on speed back at the inception of broad based electronic trade, they forgot they had to create a marketplace where everyone could participate on equal footing at the exchange window.

      When I go to the racetrack and bet win place or show, the racetrack treats me the same as the high roller or the broken down horseplayer.

    • KIR

      Back month liquidity was the first casualty of electronic trading. It disappeared for a few reasons. The most obvious was when a pit of competing, independent locals was replaced by prop shops. Prop shops require their traders to go home flat at the end of each day. By their nature, back month positions are less liquid and require patience and a willingness to inventory a position.

      • That’s a finer point no one outside of trading/hedging would understand. Back months in commodity markets are very thin. They rely on market makers to make a market. Typically, these market makers are spreaders, and when they buy one month they immediately sell another month. Electronic markets have wrecked spreading, and so that has resulted in thinner back month markets.

  • toadstool

    The primary
    maxim for allowing trading in a futures contract was that it serves to
    transfer risk “inherent” in an underlying industry. It was not to
    “create” risk. I think it can be argued that the way the market is now
    structured, it creates risk and serves a community of high speed traders
    and the CME. The cattle industry is saying that it is not being served. The electronic cattle futures contract is losing functionality as a risk transference tool and it can be argued that it is exacerbating the risk that is inherent in the underlying industry.This
    conversation strikes at the regulatory heart of this issue.

    • The faster the market goes, the more it gets distorted. There is a chance to take advantage of what Eugene Fama terms, “risk free arbitrage” when markets go hyper fast. The more opportunity for risk free arbitrage, the stronger the economic incentive to go faster.

      By slowing the market down and giving every trader access to the “top step”, exchanges will do less volume-but they will transfer risk more efficiently.

    • KIR

      Volatility used to be the product of fundamental factors impacting the underlying physical commodity. Now, volatility is caused by predatory trading strategies employed by high frequency traders.

  • RalphJolly

    Hello Jeff, I’m not sure why you say that exchange share prices are likely to get hit. Care to explain? Seat prices have been hit hard as HFT has wiped out swathes of locals, I think they would rebound, and so I am not on the same page as you with the exchange share price.
    I traded Eurex for many years and remember a period c.2000 when my screen ‘pulsed’ every second as they updated. Volumes in the Eurex bonds were high and so was liquidity -good bids and offers that you could hit. I liked it and I think it was probably the most liquid market I have ever seen.

    • The reason exchange stock prices would take a hit is that I am assuming there is a trade off. The odds are volume would decrease in a market that was not based on speed. Lower volumes mean less fees. Of course, the retail investor is gone from futures markets-and they pay higher fees.

      • RalphJolly

        Hello Jeff -I can see where you’re coming from but I don’t agree. We had good volumes and much better liquidity before HFT dominated the futures market. If the CME throws an axe in the HFT works, new players will spring up to pick up the slack -they always do in our industry. I could see volumes dipping for a maximum of a few months and then in my opinion, all other things being equal, volumes would be at least as good. Who knows, a market with a much broader base could mean much higher fee income…
        Anyway, I enjoyed reading your piece; I think that the issue of slowing down the markets needs much more discussion.

        • We had good liquidity for sure. Markets were not as volatile. Volume in the hogs was around 10k per day prior to electronic trading taking over. Now it’s double. But, the at the margin volatility is extremely high. It’s impossible to unload big positions and the risk of holding them is far greater than it was prior to electronic trading taking over. Cattle volume also increased. But, as we know, volume doesn’t equal liquidity.

          I was incorrect in my previous comment because I didn’t think it through. Lower volume in the meats wouldn’t hurt the stock price. We are talking losing 10,000-20,000 contracts per day. Even at full retail (which they aren’t) that is not a large hit to CME’s bottom line. They could make it up in one day in the Treasury complex.

  • kdn

    While the velocity of trade god is primary at the CME now, they are losing the commercial traders in most of the smaller markets as being run around, through or over is getting old for most of them. As noted lack of depth in the backs is causing many hedging accounts to go to the off exchange/private market. What no one is talking about is the ability of some of the algo’s to get/buy primacy in order placement. When you place and order and it is alone on the ladder with no competition some algo’s are able to step in and take a pending trade away from your static market. Ex: you bid for an option have someone want to hit that bid, they send the order to hit your bid and an algo steps in and buys their offer at your price while you get nothing. The algo was neither representing a market there nor were they there when the trade to hit the bid was sent, yet the algo gets the trade. Who wants to trade a market when you have both hands tied behind your back? Also of note is the fact that nobody is talking about the CME house traders and the information and speed advantages they they could/do have over all other traders. How these two things have escaped a lawsuit is somewhat mystifying.