[Senate Hearing 111-155]
[From the U.S. Government Publishing Office]
S. Hrg. 111-155
EXCESSIVE SPECULATION IN THE WHEAT MARKET
=======================================================================
HEARING
before the
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
of the
COMMITTEE ON
HOMELAND SECURITY AND
GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
----------
JULY 21, 2009
----------
Available via http://www.gpoaccess.gov/congress/index.html
Printed for the use of the Committee on Homeland Security
and Governmental Affairs
EXCESSIVE SPECULATION IN THE WHEAT MARKET
S. Hrg. 111-155
EXCESSIVE SPECULATION IN THE WHEAT MARKET
=======================================================================
HEARING
before the
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
of the
COMMITTEE ON
HOMELAND SECURITY AND
GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
__________
JULY 21, 2009
__________
Available via http://www.gpoaccess.gov/congress/index.html
Printed for the use of the Committee on Homeland Security
and Governmental Affairs
U.S. GOVERNMENT PRINTING OFFICE
53-114 WASHINGTON : 2009
-----------------------------------------------------------------------
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512�091800
Fax: (202) 512�092104 Mail: Stop IDCC, Washington, DC 20402�090001
COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan SUSAN M. COLLINS, Maine
DANIEL K. AKAKA, Hawaii TOM COBURN, Oklahoma
THOMAS R. CARPER, Delaware JOHN McCAIN, Arizona
MARK L. PRYOR, Arkansas GEORGE V. VOINOVICH, Ohio
MARY L. LANDRIEU, Louisiana JOHN ENSIGN, Nevada
CLAIRE McCASKILL, Missouri LINDSEY GRAHAM, South Carolina
JON TESTER, Montana
ROLAND W. BURRIS, Illinois
MICHAEL F. BENNET, Colorado
Michael L. Alexander, Staff Director
Brandon L. Milhorn, Minority Staff Director and Chief Counsel
Trina Driessnack Tyrer, Chief Clerk
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
CARL LEVIN, Michigan, Chairman
THOMAS R. CARPER, Delaware TOM COBURN, Oklahoma
MARK L. PRYOR, Arkansas SUSAN M. COLLINS, Maine
JON TESTER, Montana JOHN McCAIN, Arizona
MICHAEL F. BENNET, Colorado JOHN ENSIGN, Nevada
Elise J. Bean, Staff Director and Chief Counsel
Rachael Siegel, GAO Detailee
Christopher Barkley, Minority Staff Director
Timothy R. Terry, Minority Counsel
Mary D. Robertson, Chief Clerk
C O N T E N T S
------
Opening statements:
Page
Senator Levin................................................ 1
Senator Coburn............................................... 10
Senator Collins.............................................. 13
Senator Tester............................................... 15
Senator Bennet............................................... 15
Prepared statement:
Senator McCaskill............................................ 63
WITNESSES
Tuesday, July 21, 2009
Hon. Gary Gensler, Chairman, Commodity Futures Trading Commission 16
Thomas Coyle, Vice President and General Manager, Chicago and
Illinois River Marketing LLC, Nidera, Inc., and Chairman,
National Grain and Feed Association............................ 33
Hayden Wands, Director of Procurement, Sara Lee Corporation, and
Chairman, Commodity and Agricultural Policy, American Bakers
Association.................................................... 36
Mark Cooper, Director of Research, Consumer Federation of America 38
Steven H. Strongin, Head of the Global Investment Research
Division, The Goldman Sachs Group, Inc......................... 39
Charles P. Carey, Vice Chairman, CME Group....................... 52
Alphabetical List of Witnesses
Carey, Charles P.:
Testimony.................................................... 52
Prepared statement........................................... 143
Cooper, Mark:
Testimony.................................................... 38
Prepared statement........................................... 87
Coyle, Thomas:
Testimony.................................................... 33
Prepared statement........................................... 71
Gensler, Hon. Gary:
Testimony.................................................... 16
Prepared statement........................................... 64
Strongin, Steven H.:
Testimony.................................................... 39
Prepared statement........................................... 129
Wands, Hayden:
Testimony.................................................... 36
Prepared statement........................................... 76
APPENDIX
``Excessive Speculation in the Wheat Market,'' Majority and
Minority Staff Report, Permanent Subcommittee on
Investigations, June 24, 2009.................................. 159
Exhibits
1. GOutstanding Chicago Wheat Futures Contracts Purchased by
Commodity Index Traders, 2004-2009, chart prepared by the U.S.
Senate Permanent Subcommittee on Investigations................ 425
2 GChicago Wheat Prices, Daily Difference Between Futures and
Cash Price (Daily Basis), chart prepared by the U.S. Senate
Permanent Subcommittee on Investigations....................... 426
3. GChicago Wheat Prices, Difference Between Futures Price and
Cash Price (Basis) in Chicago at Contract Expiration, chart
prepared by the U.S. Senate Permanent Subcommittee on
Investigations................................................. 427
4. GExample of a Hedge With Convergence, chart prepared by the
U.S. Senate Permanent Subcommittee on Investigations........... 428
5. GExample of a Hedge Without Convergence, chart prepared by
the U.S. Senate Permanent Subcommittee on Investigations....... 429
6. GCash Price of Wheat (Soft Red Winter Wheat), chart prepared
by the U.S. Senate Permanent Subcommittee on Investigations.... 430
7. GDocument entitled The Case for Commodities as an Asset
Class, prepared by Goldman Sachs and Co., June 2004............ 431
8. GResponses to supplemental questions for the record submitted
to Charles P. Carey, Vice Chairman, CME Group.................. 498
9. GResponses to supplemental questions for the record submitted
to Steven H. Strongin, Head of the Global Investment Research
Division, The Goldman Sachs Group, Inc......................... 503
10. GResponses to supplemental questions for the record submitted
to Mark Cooper, Director of Research, Consumer Federation of
America........................................................ 507
11. GResponses to supplemental questions for the record submitted
to The Honorable Gary Gensler, Chairman, Commodities Futures
Trading Commission............................................. 510
EXCESSIVE SPECULATION IN THE WHEAT MARKET
----------
TUESDAY, JULY 21, 2009
U.S. Senate,
Permanent Subcommittee on Investigations,
Committee on Homeland Security
and Governmental Affairs,
Washington, DC.
The Subcommittee met, pursuant to notice, at 2:34 p.m., in
room SD-342, Dirksen Senate Office Building, Hon. Carl Levin,
Chairman of the Subcommittee, presiding.
Present: Senators Levin, Tester, Bennet, Coburn, and
Collins.
Staff Present: Elise J. Bean, Staff Director and Chief
Counsel; Mary D. Robertson, Chief Clerk; Rachel Siegel,
Detailee (GAO); David Katz, Counsel; Allison Murphy, Counsel;
Christopher Barkley, Staff Director to the Minority; Timothy R.
Terry, Counsel to the Minority; Marcelle John, Detailee (IRS);
Kevin Wack, Congressional Fellow; Sam Katsin, Intern; Peter
Kenny, Law Clerk; Malachi Zussman-Dobbins, Intern; Melissa Mann
(Senator McCaskill); Nichole Distefano (Senator McCaskil);
Jason Rosenberg (Senator Tester); Rachel Clark (Senator
Tester); Catharine Ferguson (Senator Bennet); Brandon Milhorn
(HSGAC/Senator Collins); Asha Mathew (HSGAC/Senator Collins);
and Mary Beth Carozza (HSGAC/Senator Collins).
OPENING STATEMENT OF SENATOR LEVIN
Senator Levin. Good afternoon, everybody. The Subcommittee
will come to order.
For more than 5 years now, this Subcommittee has been
taking a hard look at how our commodity markets function. In
particular, we have examined how excessive speculation in those
markets has distorted prices, overwhelmed normal supply and
demand factors, and can push up prices at the expense of
consumers and American business.
In 2006, for example, the Subcommittee released a report
which found that billions of dollars in commodity index trading
on the crude oil market had pushed up futures prices in 2006,
causing a corresponding increase in cash prices, and were
responsible for an estimated $20 out of the then $70 cost for a
barrel of oil. A 2007 report showed how a single hedge fund
named Amaranth made huge trades on the natural gas market,
pushed up futures prices, and increased natural gas prices for
consumers and American business.
At today's hearing, our focus is on wheat. Using the wheat
market as a case history, we show how commodity index trading,
in the aggregate, can cause excessive speculation and price
distortions. As in our prior investigations, this examination
has taken us into the upside down world of financial
engineering that we find ourselves in today, where instead of
talking about supply and demand affecting wheat prices, we have
to talk about the impact of complex financial instruments like
commodity indexes, swaps, and exchange traded funds, and what
happens when speculators buying these derivative instruments
begin to dominate a futures market instead of the commercial
businesses buying futures to hedge against price changes.
These are complicated issues. It took the Subcommittee an
entire year to compile and analyze millions of trading records
from the three U.S. futures markets where wheat is traded,
including the largest exchange of the three in Chicago. We also
interviewed numerous experts, researched the issues, and
released a 247-page report explaining our findings.
Our report, which was issued by myself and Senator Coburn
last month, concludes that the huge number of wheat futures
contracts being purchased by derivative dealers selling
commodity index instruments have, in the aggregate, constituted
excessive speculation in the Chicago wheat market, resulting in
unwarranted price changes and an undue burden on commerce.
Our report presents a variety of data in support of its
findings, but, necessarily, I can highlight only a few key
points here. The first point is the huge growth in commodity
index investments over the past 5 years. According to estimates
by the Commodity Futures Trading Commission (CFTC), about $15
billion was invested in commodity indexes in 2003. By mid-2008,
that figure had grown to $200 billion, a 13-fold increase.
Commodity indexes are mathematical constructs whose value
is calculated from the value of a specified basket of futures
contracts for agricultural, energy, and metals commodities.
When the prices of the selected futures go up, the value of the
index goes up. When the futures prices go down, the index value
goes down.
Speculators don't invest directly in a commodity index,
since the index itself is nothing more than a number that
constantly changes. Instead, they buy financial instruments--
derivatives--whose value is linked to the value of a specified
commodity index. In essence, speculators place bets on whether
the index value will go up or down. They place those bets with
derivative dealers, usually by buying a financial instrument
called a ``swap'' whose value is linked to the commodity index.
The derivative dealer charges a fee for entering the swap, and
then effectively holds the other side of the bet. When the
index value goes up, the speculator makes money from the swap.
When the index value goes down, the derivative dealer makes
money from the swap.
Most derivative dealers, however, don't like to gamble on
these swaps; instead they typically hedge their bets by buying
the futures contracts on which the index and related swaps are
based. Then if their side of the swap loses value, they offset
the loss with the increased value of the underlying futures. By
holding both the swap and the futures contracts upon which the
swap is based, derivative dealers are protected from financial
risk whether futures prices go up or down. By taking that
position, derivative dealers also avoid becoming pure
speculators in commodities; instead, they facilitate the
speculative bets being placed by their clients, while making
money off the fees paid for the commodity index swaps.
Since 2004, derivative dealers buying futures to offset the
speculative bets made by their clients have begun to dominate
U.S. commodity markets, buying a wide range of futures for
crude oil, natural gas, gold, corn, wheat, and other
commodities. This chart, Exhibit 1,\1\ shows the impact on the
Chicago wheat futures market alone. It shows that derivative
dealers making commodity index trades have bought increasing
numbers of wheat futures, with their aggregate holdings going
from 30,000 wheat contracts in 2004 to 220,000 in 2008, a
seven-fold increase in 4 years. Derivative dealers making
commodity index trades now hold nearly half of the outstanding
wheat futures--long open interest--on the Chicago Exchange.
---------------------------------------------------------------------------
\1\ See Exhibit No. 1, which appears in the Appendix on page 425.
---------------------------------------------------------------------------
Derivative dealers seeking to offset the speculative bets
of their clients have created a new demand for futures
contracts. Their objective is simple: to buy a sufficient
number of futures to offset their financial risk from selling
commodity index swaps to their clients. Their steady purchases
of futures to buy wheat have had a one-way impact on futures
prices--pushing the prices up. In addition, their purchases
have created a steady demand for wheat futures, without
creating a corresponding demand in the cash market. The result
in recent years has been Chicago wheat futures prices which are
routinely much higher than wheat cash prices, with a persistent
and sizable gap between the two prices.
Now, the next two charts show how this gap has grown over
time. The first chart, Exhibit 2,\2\ looks at the day-to-day
difference between wheat futures and cash prices in the Chicago
wheat market over the last 9 years. It shows that, from 2000 to
2005, the average daily difference between the average cash and
futures price for wheat in the Chicago market, also called the
``basis,'' ranged between 0 and 50 cents. In 2006, that price
gap or basis began to increase, in sync with the increasing
amount of commodity index trading going on in the Chicago wheat
market. By mid-2008, when commodity index traders held nearly
half of the outstanding wheat futures--long open interest--on
the Chicago Exchange, the price gap had grown to between $1.50
and $2 per bushel, a huge and unprecedented gap.
---------------------------------------------------------------------------
\2\ See Exhibit No. 2, which appears in the Appendix on page 426.
---------------------------------------------------------------------------
Now, the next chart, which is Exhibit 3 \3\ in the books,
shows the same pattern when the Chicago wheat futures contracts
expired. Wheat futures contracts are available in only 5 months
of the year--March, May, July, September, and December. This
chart looks at the expiration date for each of those five
contracts from 2005 to 2008 and shows the gap between the final
futures price and the cash price on that date. The data shows
that this gap, or the basis, grew from 13 cents per bushel in
2005, to 34 cents in 2006, to 60 cents in 2007, to $1.53 in
2008, a more than ten-fold increase in 4 years, providing clear
evidence of a dysfunctional market. And, again, this increasing
price gap took place at the same time commodity index traders
were increasing their holdings to nearly half of the wheat
futures contracts on the Chicago Exchange.
---------------------------------------------------------------------------
\3\ See Exhibit No. 3, which appears in the Appendix on page 427.
---------------------------------------------------------------------------
To understand the significance of this price gap, we need
to take a step back and focus on the purpose of commodity
markets. Commodity markets have traditionally had two primary
purposes: first, to help farmers and other businesses establish
a price for the delivery of a commodity at a specified date in
the future; and, second, to help them hedge against the risk of
price changes over time.
Futures prices are the result of numerous traders making
individual bids to buy or sell a standard amount of the
commodity at a specified date in the future. That date can be 1
month, 6 months, or even years in the future. At the same time
this bargaining is going on to establish prices for the future
delivery of a commodity, businesses are also bargaining over
prices for the immediate delivery of that commodity. A price
for the immediate delivery of a commodity is referred to as the
cash price. Traditionally, futures prices and cash prices have
worked together. That is because, as the delivery date in a
futures contract gets closer, the futures price logically
should begin to converge with the cash price so that, on the
date the futures contract expires and delivery is due, the two
prices are very close.
Now that is what is supposed to happen. But in some
commodity markets like the wheat market, price convergence has
broken down. When price convergence breaks down, hedges stop
working and no longer protect farmers, grain elevators, grain
merchants, food producers, and others against price changes.
And we will hear today how these businesses are losing the
ability to hedge in the Chicago wheat market and are incurring
unanticipated costs from failed hedges and higher margin costs.
We will also hear how, in many cases, those businesses have to
eat those costs because the fierce competition over food prices
won't allow them to increase their prices to cover the extra
expense. In other cases, when they do pass on those higher
costs, consumers, of course, lose.
Virtually everyone this Subcommittee has contacted agrees
that price convergence is critical to successful hedging. When
the futures and cash prices don't converge at the time a
futures contract expires, hedges don't work. There is no
dispute over that. In the prepared statement, which I will put
in the record, I provide a detailed explanation of why price
convergence is essential to effective hedging. In the interest
of time and because there is pretty much a consensus in support
of that point, I am not going to repeat that explanation here.
The key issue is what is causing the prices not to
converge. While there are many possible contributing factors,
including artificially low storage prices or delivery problems,
our investigation found substantial and persuasive evidence
that the primary reason why prices have not been converging in
the Chicago wheat market is the large number of wheat contracts
being purchased by derivative dealers making commodity index
trades.
Those derivative dealers have been selling billions of
dollars in commodity index swaps to customers speculating on
commodity prices. By purchasing futures contracts to offset
their financial risk, derivative dealers created an additional
demand for wheat futures that is unconnected to the cash
market, and that has contributed to the gap between the two
prices. We know of no other significant change in the wheat
market over the past 5 years which explains the failure to
converge other than the huge surge of wheat futures bought by
derivative dealers offsetting the sale of commodity index swaps
to their clients. I emphasize the word ``significant.'' We know
of no other significant change in the wheat market over the
past 5 years.
The massive commodity index trading affecting the wheat
futures market in recent years was made possible in part by
regulators. Existing law requires the CFTC to set limits on the
number of futures contracts that any one trader can hold at any
one time to prevent excessive speculation and other trading
abuses. Those position limits are supposed to apply to all
traders, unless granted an exemption or a waiver by the CFTC.
With respect to wheat, the CFTC has established a limit
that prohibits any trader from holding more than 6,500 futures
contracts at any one time. But over the years, the CFTC has
also allowed some derivative dealers to exceed that limit. The
CFTC granted exemptions to four derivative dealers that sell
commodity index swaps, allowing them to hold up to 10,000,
17,500, 26,000, and even 53,000 wheat futures at a time. The
CFTC also issued two ``no-action'' letters allowing the manager
of one commodity index exchange-traded fund to hold up to
11,000 wheat futures and another fund manager to hold up to
13,000 wheat futures. Together, those exemptions and waivers by
the CFTC permit six derivative dealers to hold a total of up to
130,000 wheat futures contracts at any one time, instead of
39,000, or two-thirds less, if the standard limit had applied.
Part of the reason that the CFTC granted these exemptions
and waivers was because it got mixed signals from Congress. In
the Commodities Exchange Act, Congress told the CFTC to set
position limits to prevent excessive speculation, and it
authorized the CFTC to grant exemptions only for commercial
users needing to hedge transactions involving physical
commodities in the cash market. But in 1987, two key
congressional committees also told the CFTC to consider
granting exemptions to financial firms seeking to offset purely
financial risks. It was in response to this direction that the
CFTC eventually allowed the derivative dealers selling
commodity index instruments to exceed the standard limits.
These exemptions and waivers have enabled derivative
dealers to place many more speculative bets for their customers
than they could have otherwise, resulting in an increased
demand for wheat futures contracts to offset the financial
risk, higher wheat futures prices unconnected to cash prices,
failed hedges, and higher margin costs.
That is why our report recommends that the CFTC reinstate
the standard 6,500 limit on wheat contracts for derivative
dealers. Imposing this limit again would reduce commodity index
trading in the wheat market and take some of the pressure off
wheat futures prices. If wheat futures prices remain higher
than cash prices after the existing exemptions and waivers are
phased out, our report recommends tightening the limit further,
perhaps to 5,000 wheat contracts per derivative dealer, which
is the limit that existed up until 2006.
Our report also recommends that the CFTC examine other
commodity markets to see if commodity index trading has
resulted in excessive speculation and undue price changes. This
Subcommittee has said before that excessive speculation is
playing a damaging role in other commodity markets, especially
the crude oil market where oil prices go up despite low demand
and ample supplies. And I might add here that our full
Committee has done some significant investigations and hearings
on the same subject under the leadership of Chairman Lieberman
and Ranking Member Collins.
The CFTC has promised a top-to-bottom review of the
exemptions and waivers it has granted to derivative dealers and
has signaled its willingness to use position limits to clamp
down on excessive speculation in all commodity markets, to
ensure that commodity prices reflect supply and demand rather
than speculators gambling on market prices to turn a quick
profit. That review is badly needed, and we appreciate the
agency's responsiveness to the turmoil in the markets.
[The prepared statement of Senator Levin follows:]
PREPARED OPENING STATEMENT OF SENATOR LEVIN
For more than five years now, this Subcommittee has been taking a
hard look at how our commodity markets function. In particular, we have
examined how excessive speculation in those markets has distorted
prices, overwhelmed normal supply and demand factors, and can push up
prices at the expense of consumers and American business.
In 2006, for example, the Subcommittee released a report which
found that billions of dollars in commodity index trading on the crude
oil market had pushed up futures prices in 2006, caused a corresponding
increase in cash prices, and were responsible for an estimated $20 out
of the then $70 cost for a barrel of oil. A 2007 report showed how a
single hedge fund named Amaranth made huge trades on the natural gas
market, pushed up futures prices, and increased natural gas prices for
consumers and American business.
At today's hearing, our focus is on wheat. Using the wheat market
as a case history, we show how commodity index trading, in the
aggregate, can cause excessive speculation and price distortions. As in
our prior investigations, this examination has taken us into the upside
down world of financial engineering that we find ourselves in today,
where instead of talking about supply and demand affecting wheat
prices, we have to talk about the impact of complex financial
instruments like commodity indexes, swaps, and exchange traded funds,
and what happens when speculators buying these derivative instruments
begin to dominate a futures market instead of the commercial businesses
buying futures to hedge against price changes.
These are complicated issues. It took the Subcommittee an entire
year to compile and analyze millions of trading records from the three
U.S. futures markets where wheat is traded, including the largest
exchange of the three in Chicago. We also interviewed numerous experts,
researched the issues, and released a 247-page report explaining our
findings. Our report, which was issued by myself and Senator Coburn
last month, concludes that the huge number of wheat futures contracts
being purchased by derivative dealers selling commodity index
instruments have, in the aggregate, constituted excessive speculation
in the Chicago wheat market, resulting in unwarranted price changes and
an undue burden on commerce.
Our report presents a variety of data in support of its findings,
but, necessarily, I can highlight only a few key points here. The first
point is the huge growth in commodity index investments over the past
five years. According to estimates by the Commodity Futures Trading
Commission (CFTC), about $15 billion was invested in commodity indexes
in 2003. By mid-2008, that figure had grown to $200 billion, a
thirteenfold increase.
Commodity indexes are mathematical constructs whose value is
calculated from the value of a specified basket of futures contracts
for agricultural, energy, and metals commodities. When the prices of
the selected futures go up, the value of the index goes up. When the
futures prices go down, the index value goes down.
Speculators don't invest directly in a commodity index, since the
index itself is nothing more than a number that constantly changes.
Instead, they buy financial instruments--derivatives--whose value is
linked to the value of a specified commodity index. In essence,
speculators place bets on whether the index value will go up or down.
They place those bets with derivative dealers, usually by buying a
financial instrument called a ``swap'' whose value is linked to the
commodity index. The derivative dealer charges a fee for entering the
swap, and then effectively holds the other side of the bet. When the
index value goes up, the speculator makes money from the swap. When the
index value goes down, the derivative dealer makes money from the swap.
Most derivative dealers, however, don't like to gamble on these
swaps; instead they typically hedge their bets by buying the futures
contracts on which the index and related swaps are based. Then if their
side of the swap loses value, they offset the loss with the increased
value of the underlying futures. By holding both the swap and the
futures contracts upon which the swap is based, derivative dealers are
protected from financial risk whether futures prices go up or down. By
taking that position, derivative dealers also avoid becoming pure
speculators in commodities, instead facilitating the speculative bets
being placed by their clients, while making money off the fees paid for
the commodity index swaps.
Since 2004, derivative dealers buying futures to offset the
speculative bets made by their clients have begun to dominate U.S.
commodity markets, buying a wide range of futures for crude oil,
natural gas, gold, corn, wheat and other commodities. This chart,
Exhibit 1, shows the impact on the Chicago wheat futures market alone.
It shows that derivative dealers making commodity index trades have
bought increasing numbers of wheat futures, with their aggregate
holdings going from 30,000 wheat contracts in 2004, to 220,000 in 2008,
a sevenfold increase in four years. Derivative dealers making commodity
index trades now hold nearly half of the outstanding wheat futures
(long open interest) on the Chicago Exchange.
Derivative dealers seeking to offset the speculative bets of their
clients have created a new demand for futures contracts. Their
objective is simple: to buy a sufficient number of futures to offset
their financial risk from selling commodity index swaps to clients.
Their steady purchases of futures to buy wheat have had a one-way
impact on futures prices--pushing the prices up. In addition, their
purchases have created a steady demand for wheat futures, without
creating a corresponding demand in the cash market. The result in
recent years has been Chicago wheat futures prices which are routinely
much higher than wheat cash prices, with a persistent and sizeable gap
between the two prices.
The next two charts show how this gap has grown over time. The
first chart, Exhibit 2, looks at the day-to-day difference between
wheat futures and cash prices in the Chicago wheat market over the last
nine years. It shows that, from 2000 to 2005, the average daily
difference between the average cash and futures price for wheat in the
Chicago market, also called the basis, ranged between 0 and 50 cents.
In 2006, that price gap or basis began to increase, in sync with the
increasing amount of commodity index trading going on in the Chicago
wheat market. By mid 2008, when commodity index traders held nearly
half of the outstanding wheat futures (long open interest) on the
Chicago Exchange, the price gap had grown to between $1.50 and $2 per
bushel, a huge and unprecedented gap.
The next chart, Exhibit 3, shows the same pattern when the Chicago
wheat futures contracts expired. Wheat futures contracts are available
in only five months of the year, March, May, July, September, and
December. This chart looks at the expiration date for each of those
five contracts from 2005 to 2008, and shows the gap between the final
futures price and the cash price on that date. The data shows that this
gap, or basis, grew from 13 cents per bushel in 2005, to 34 cents in
2006, to 60 cents in 2007, to $1.53 in 2008, a more than ten-fold
increase in four years, providing clear evidence of a dysfunctional
market. And again, this increasing price gap took place at the same
time commodity index traders were increasing their holdings to nearly
half of the wheat futures contracts on the Chicago Exchange.
To understand the significance of this price gap, we need to take a
step back and focus on the purpose of commodity markets. Commodity
markets have traditionally had two primary purposes: first, to help
farmers and other businesses establish a price for the delivery of a
commodity at a specified date in the future, and, second, to help them
hedge against the risk of price changes over time.
Futures prices are the result of numerous traders making individual
bids to buy or sell a standard amount of the commodity at a specified
date in the future. That date can be one month, six months, or even
years in the future. At the same time this bargaining is going on to
establish prices for the future delivery of a commodity, businesses are
also bargaining over prices for the immediate delivery of that
commodity. A price for the immediate delivery of a commodity is
referred to as the cash price. Traditionally, futures prices and cash
prices have worked together. That's because, as the delivery date in a
futures contract gets closer, the futures price logically should begin
to converge with the cash price so that, on the date the futures
contract expires and delivery is due, the two prices are very close.
That's what supposed to happen. But in some commodity markets like
the wheat market, price convergence has broken down. When price
convergence breaks down, hedges stop working and no longer protect
farmers, grain elevators, grain merchants, food producers, and others
against price changes. We will hear today how these businesses are
losing the ability to hedge in the Chicago wheat market, and are
incurring unanticipated costs from failed hedges and higher margin
costs. We will also hear how, in many cases, those businesses have to
eat those costs because the fierce competition over food prices won't
allow them to increase their prices to cover the extra expense. In
other cases, when they do pass on those higher costs, consumers lose.
Virtually everyone this Subcommittee has contacted agrees that
price convergence is critical to hedging. When the futures and cash
prices don't converge at the time a futures contract expires, hedges
don't work. Let me explain in more detail why price convergence is
critical to the ability of farmers, elevators, and others to use the
futures markets to manage their price risks. Let's use the example of a
county grain elevator that buys wheat from a local farmer, stores it,
and sells the grain to a major bakery later in the year.
When the grain elevator buys the wheat and stores it, the value of
that grain will fluctuate as grain prices change over time. If grain
prices go up, the wheat is worth more. If prices go down, the wheat is
worth less and could even drop below what the elevator paid for it. To
protect itself, the elevator typically turns to the futures market to
hedge its price risk.
This chart, Exhibit 4, shows how the elevator uses the futures
market to protect itself from a drop in wheat prices. The example
assumes the grain elevator bought wheat on July 15 for $4 per bushel
and wants to sell it to a bakery in December. In July, when the
elevator buys the wheat, it checks the futures prices and finds that
the price for delivering wheat in December is $6 per bushel. Since that
price is $2 more than what it paid for the wheat, the elevator wants to
lock in that gain. So in July, the elevator obtains a futures contract
to deliver a standard amount of wheat to a specified storage warehouse
in December at $6 per bushel.
The grain elevator is now said to be ``hedged,'' because it has
grain in storage--which is called being ``long'' in the cash market--
and a futures contract to deliver wheat at a specified price in the
future--which is called being ``short'' in the futures market. In a
properly functioning futures market, any loss in the cash value of the
stored wheat from July to December should be offset by a gain in the
value of its futures contract over the same period.
Here's how it works. When December arrives, the elevator acts to
``unwind'' its hedge so that it doesn't have to actually incur the
expense of delivering its wheat as the futures contract specifies--to a
faraway warehouse--and can instead deliver it to its customer, the
bakery. To offset its obligation to deliver wheat in December, the
elevator goes onto the futures market in December and buys a futures
contract obligating it to take delivery of the same amount of wheat
during that same month of December. The contract to buy wheat in
December can then be used to offset the $6 per bushel contract to sell
wheat in December, and the two futures cancel out. The elevator is then
free to sell its stored wheat to the bakery at the prevailing cash
price.
The key to a successful hedge here is whether the December cash and
the December futures prices have converged. The example on the chart
assumes that both the cash and futures prices have converged in
December to $3 per bushel. That means the elevator, in December, can
buy a December futures contract to take delivery of wheat at $3 per
bushel, offset it against its contract promising to sell wheat in
December for $6 per bushel, and realize a net gain of $3 in the futures
market. In the cash market, the elevator can sell its grain to the
bakery at the prevailing cash price of $3 per bushel, which is a $1 per
bushel loss compared to the $4 it paid to buy the wheat. But that $1
loss in the cash market, when subtracted from the $3 gain in the
futures market, results in an overall gain of $2 per bushel--exactly
what the elevator sought when it initiated the hedge in July.
The December price convergence was critical to the success of the
elevator's hedging strategy. It is only because the December wheat
futures price and the December wheat cash price were the same that the
grain elevator was able to offset its December futures and December
cash transactions, and realize the $2 gain promised by its hedge in
July.
The next chart, Exhibit 5, shows what happens when the cash and
futures prices don't converge. This chart uses the same assumptions--
that, in July, the grain elevator purchased wheat from a farmer for $4
per bushel and obtained a futures contract promising to sell the wheat
for $6 per bushel in December. In this example, however, the futures
price stays higher than the cash price throughout the life of the
hedge. When the futures contract expires in December, the December
futures price is $5 per bushel, while the December cash price is $3.
That means when the elevator buys a futures contract in December to
offset its earlier hedge, it will have to buy a futures contract at $5
per bushel, which when offset against its futures contract to sell the
wheat for $6 per bushel, results in a net gain in the futures market of
only $1 per bushel. In the cash market, the elevator still sells the
wheat that it bought at $4 per bushel to the bakery for $3, resulting
in a loss of $1 per bushel. Subtracting the $1 loss in the cash market
from the $1 gain in the futures market leaves the elevator without any
net gain to pay its expenses.
If the elevator hadn't bought a futures contract in December to
unwind its hedge that way, it could have lost out even more, by having
to pay the costs of transporting its wheat to an approved warehouse in
December. The point of the hedge made in July was not to deliver wheat
to a warehouse in December, but to lock in a gain and protect it from
price changes. The effectiveness of that hedge requires price
convergence, however, and that's exactly what has been lacking on too
many occasions in the Chicago wheat market in recent years.
The key issue is what is causing the prices not to converge. While
there are many possible contributing factors, including artificially
low storage costs or delivery problems, our investigation found
substantial and persuasive evidence that the primary reason why prices
have not been converging in the Chicago wheat market is the large
number of wheat contracts being purchased by derivative dealers making
commodity index trades. Those derivative dealers have been selling
billions of dollars in commodity index swaps to customers speculating
on commodity prices. By purchasing futures contracts to offset their
financial risk, derivative dealers created an additional demand for
wheat futures that is unconnected to the cash market, and that has
contributed to the gap between the two prices. We know of no other
significant change in the wheat market over the past five years which
explains the failure to converge other than the huge surge of wheat
futures bought by derivative dealers offsetting the sale of commodity
index swaps to their clients.
The massive commodity index trading affecting the wheat futures
market in recent years was made possible in part by regulators.
Existing law requires the CFTC to set limits on the number of futures
contracts that any one trader can hold at any one time to prevent
excessive speculation and other trading abuses. Those position limits
are supposed to apply to all traders, unless granted an exemption or
waiver by the CFTC.
With respect to wheat, the CFTC has established a limit that
prohibits any trader from holding more than 6,500 futures contracts at
any one time. But over the years, the CFTC has also allowed some
derivative dealers to exceed that limit. The CFTC granted exemptions to
four derivative dealers that sell commodity index swaps, allowing them
to hold up to 10,000, 17,500, 26,000, and even 53,000 wheat futures at
a time. The CFTC also issued two ``no-action'' letters allowing the
manager of one commodity index exchange traded fund to hold up to
11,000 wheat futures and another fund manager to hold up to 13,000
wheat futures. Together, these exemptions and waivers permit six
derivative dealers to hold a total of up to 130,000 wheat futures
contracts at any one time, instead of 39,000, or two-thirds less, if
the standard limit had applied.
Part of the reason that the CFTC granted these exemptions and
waivers was because it got mixed signals from Congress. In the
Commodities Exchange Act, Congress told the CFTC to set position limits
to prevent excessive speculation, and authorized the CFTC to grant
exemptions only for commercial users needing to hedge transactions
involving physical commodities in the cash market. But in 1987, two key
Congressional Committees also told the CFTC to consider granting
exemptions to financial firms seeking to offset purely financial risks.
It was in response to this direction that the CFTC eventually allowed
the derivative dealers selling commodity index instruments to exceed
the standard limits.
These exemptions and waivers have enabled derivative dealers to
place many more speculative bets for their customers than they could
have otherwise, resulting in an increased demand for wheat futures
contracts to offset the financial risk, higher wheat futures prices
unconnected to cash prices, failed hedges, and higher margin costs.
That's why our report recommends that the CFTC reinstate the
standard 6,500 limit on wheat contracts for derivative dealers.
Imposing this limit would reduce commodity index trading in the wheat
market and take some of the pressure off wheat futures prices. If wheat
futures prices remain higher than cash prices after the existing
exemptions and waivers are phased out, our report recommends tightening
the limit further, perhaps to 5,000 wheat contracts per derivative
dealer, which is the limit that existed up until 2006.
Our report also recommends that the CFTC examine other commodity
markets to see if commodity index trading has resulted in excessive
speculation and undue price changes. This Subcommittee has said before
that excessive speculation is playing a damaging role in other
commodity markets, especially the crude oil market where oil prices go
up despite low demand and ample supplies.
The CFTC has promised a top-to-bottom review of the exemptions and
waivers it has granted to derivative dealers, and signaled its
willingness to use position limits to clamp down on excessive
speculation in all commodity markets, to ensure commodity prices
reflect supply and demand rather than speculators gambling on market
prices to turn a quick profit. That review is sorely needed, and we
appreciate the agency's responsiveness to the turmoil in the markets.
I am grateful to my Ranking Member, Senator Coburn, and his staff
for their participation in and support of this bipartisan
investigation, and I would like to turn to him now for his opening
statement.
Senator Levin. I am very grateful to my Ranking Member,
Senator Coburn, and his staff for their participation in and
their support of this bipartisan investigation, and I turn to
him now for his opening statement. Dr. Coburn.
OPENING STATEMENT OF SENATOR COBURN
Senator Coburn. Senator Levin, thank you very much and let
me, first of all, tell you what a pleasure it is to get to work
with you and to tell you how highly I think of your staff on
this Subcommittee. They have been very helpful, and I have
learned a great deal. This is the second hearing that I have
been with Senator Levin on.
Let me thank you for having the hearing. The people of
Oklahoma, I think, are uniquely invested in the commodities
market, not just the wheat but the oil and natural gas, and the
subject is appropriate for them.
As most people know, Oklahoma is the delivery point of West
Texas Intermediate crude, the global benchmark. It is delivered
not far from my home, and we also produce a tremendous amount
of hard red winter wheat. So coming from a farming State, I
have had a particular interest in this, and I am pleased with
today's hearing. And I have also heard from hundreds of our
constituents, especially in the last year, that got caught in a
bind in what happened.
I understand that commodity markets exist to help buyers
and sellers price their goods efficiently and to manage risks
associated with producing and carrying inventory, with
acquiring financing, with unanticipated price changes over
time. Seasonally-produced crops such as wheat can be
particularly vulnerable to some of these risks.
At the outset, however, I want to be clear. I do not
believe we are alleging any wrongdoing on the part of index
investors or anyone else. These investments represent
individuals making economic choices in a free market, regular
Americans seeking slightly better returns for their university
endowments, their stock portfolios, or their retirement funds.
Index investors are really nothing more than many of us who
have gotten somewhat more sophisticated in how we spread our
risk and how we invest.
Nor are we alleging that index investors caused high cash
commodity prices or that they are somehow responsible for more
expensive consumer goods, like cereal, crackers, and bread. Our
investigation did not show that. Our investigation did,
however, reveal that an abundance of long open interest helped
to inflate futures prices and thereby disconnect future prices
from cash prices, impairing farmers' and elevator operators'
ability to hedge price risk. Because, in the absence of
convergence, elevator operators are often forced to liquidate
their stock at a cash price well below the futures price at
which they had established their hedges. This results in
expensive and unnecessary losses and drives market participants
not to use the futures market at all, and that is hardly a
desirable result for us.
Very few industry participants disagree that index fund
participation contributed to the problems in the Chicago wheat
market. For most, however, the focus of their criticism was not
the index investors but the CME contract, which they believe
created persistent structural problems in a market that the
large index influx merely exacerbated.
So what is the best solution? Frankly, I agree with Mr.
Coyle, with the National Grain and Feed Association, that a
free-market solution is most desirable, and I too prefer to see
the wheat contract come back into balance with minimal
intervention by the Federal Government. Is that possible?
On the one hand, it has not yet done so, but, on the other
hand, we have seen some recent changes to the CME contract that
I hope will be sufficient. I applaud the CME for their
recently-implemented contract changes; noting that just this
month it amended its wheat contract, chiefly to provide for
additional delivery locations and to increase the storage rate
for wheat.
Last, a word of caution. Like a lot of ``solutions'' to
complex problems that Congress oftentimes gets involved in,
including those offered here today--like compelled load-out,
additional delivery points, higher storage fees, and even our
own report's recommendation--carry the risk of unintended
consequences. While there is little doubt that scaling back
index participation will work to improve convergence, investor
capital does not stand idle for long, and interest will flow
into other products and other markets, perhaps overseas.
The world is flat when it comes to world economic and
financial considerations, and global competition for capital
has become more fierce than ever before. The United States is
losing this competition to countries like Singapore,
Luxembourg, Hong Kong, and especially the U.K. Nations such as
these are making smarter tax and regulatory policies, and these
decisions are paying great dividends in the form of increased
jobs and investments for their citizens. These countries
understand that financial activity, especially those relating
to derivatives and money management, crosses international
borders with the greatest of ease, and they have rolled out the
welcome mat for them.
So our challenge is to, as unintrusively as possible, help
to restore the balance to the Chicago market and help to ensure
a well-functioning marketplace, one with a helpful balance of
liquidity, volatility, and risk, and one that does not
necessarily harm economic activity.
I thank the witnesses who are here today for their
testimony and the time that they spent preparing that, and I
would note, Mr. Chairman, at 4 to 4:30 p.m., I will have to be
gone, but I will return.
PREPARED OPENING STATEMENT OF SENATOR COBURN
Mr. Chairman, I want to thank you for calling this important
hearing. The people of Oklahoma are, I think, uniquely invested in the
commodities markets and are interested in the subject at hand. Oklahoma
is the delivery point of West Texas Intermediate crude oil, the global
benchmark. It's delivered in Cushing, Oklahoma, not far from my home
town of Muskogee. My state also produces a tremendous amount of ``hard
red winter wheat.'' So, coming from a farming state, I have had a
particular interest in this investigation and am pleased with today's
hearing.
Commodity markets exist to help buyers and sellers price their
goods efficiently and to manage risks--risks associated with producing
and carrying inventory, with acquiring financing, with unanticipated
price changes over time. Seasonally produced crops--such as wheat--can
be particularly vulnerable to some of these risks. I know--I have a lot
of friends back home who are farmers, merchants, and elevator
operators, and I can tell you they're hurting. As if soaring energy and
fertilizer costs last year weren't enough, folks also had to deal with
volatile wheat prices at home, an evaporation of credit (if not
outright insolvency) at their bank, and a stronger dollar that made
their product less competitive abroad--where much of the Oklahoma wheat
crop ends up. All of this on top of a persistent, years-long
nonconvergence problem in the Chicago wheat market.
At the outset, however, I want to be clear: we are not alleging any
wrongdoing on the part of index investors or anyone else; these
investments represent individuals making economic choices in a free
market, regular Americans seeking slightly better returns for their
university endowments, stock portfolios, and retirement funds. Index
investors are really nothing more than teachers, firefighters,
policemen and average hardworking people. Nor are we alleging that
index investors caused high cash commodity prices or that they are
somehow responsible for more expensive consumer goods like cereal,
crackers, and bread. Our investigation did not support such
conclusions.
Our investigation did, however, reveal that an abundance of long
open interest helped to inflate futures prices and thereby disconnect
futures from cash prices, impairing farmers' and elevator operators'
ability to hedge price risk. Because, in the absence of convergence,
elevator operators are often forced to liquidate their stocks at a cash
price well below the futures price at which they had establish their
hedges. This results in expensive and unnecessary losses and drives
market participants not to use the futures market at all, hardly a
desirable result.
Very few industry participants disagreed that index fund
participation contributed to the problems in the Chicago wheat market.
For most, the focus of their criticism was not the index investors, but
the CME contract, which they believe created persistent structural
problems in a market that the large index influx merely exacerbated.
So what is the best solution? Frankly, I agree with Mr. Coyle, with
the National Grain and Feed Association, that a free market solution is
most desirable, and I, too, ``prefer to see the wheat contract come
back into balance with minimal intervention'' from the federal
government. The question is: is this possible? On the one hand it has
not yet done so, but on the other we have seen some recent changes to
the CME contract that I hope will do the trick. I applaud the CME for
their recently-implemented contract changes. Just this month, it
amended its wheat contract, chiefly to provide for additional delivery
locations and to increase the storage rate for wheat.
Lastly, a word of caution: like a lot of ``solutions'' to complex
problems, those offered here today--compelled load-out, additional
delivery points, higher storage fees and even our own report's
recommendation--carry the risk of unintended consequences. While there
is little doubt that scaling back index participation will work to
improve convergence, investor capital does not stand idle for long, and
interest will flow into other products and other markets, perhaps
overseas. The world is ``flat,'' and global competition for capital has
become more fierce than ever before. The United States is losing this
competition to countries like Singapore, Luxembourg, Hong Kong, and
especially the U.K. Nations such as these are making smarter tax and
regulatory policies, and these decisions are paying great dividends in
the form of increased jobs and investment. These countries understand
that financial activity--especially those relating to derivatives and
money management--crosses international borders with the greatest of
ease, and they have rolled out the welcome mat.
So our challenge is to, as unintrusively as possible, help to
restore balance to the Chicago market and help to ensure a well-
functioning marketplace, one with a helpful balance of liquidity,
volatility, and risk, and one that does not unnecessarily harm economic
activity.
I thank the witnesses for their presence here today and look
forward to hearing their testimony.
Senator Levin. Thank you so much, Dr. Coburn.
Let me now call our first witness for this afternoon's
hearing: Gary Gensler, the new Chairman of the Commodity
Futures Trading Commission, your first appearance before the
Subcommittee. We welcome you.
Pursuant to Rule VI, all witnesses who testify before this
Subcommittee are required to be sworn, so I would ask you to
please stand and raise your right hand. Do you swear that the
testimony you are about to give this Subcommittee will be the
truth, the whole truth, and nothing but the truth, so help you,
God?
Mr. Gensler. I do.
Senator Levin. Oh, I am sorry. Senator Collins, apparently
had an opening statement, and in that case, I will interrupt
Dr. Gensler's testimony and call on you, Senator Collins.
OPENING STATEMENT OF SENATOR COLLINS
Senator Collins. Thank you, Mr. Chairman. I will not delay
the testimony long, but I do appreciate the opportunity to make
just a few comments.
First of all, Mr. Chairman, let me thank you and recognize
you for your many years of leadership in exposing excessive
speculation, market abuses, and manipulation. As you kindly
mentioned, last year Chairman Lieberman and I held a series of
hearings investigating the skyrocketing price of energy and
agricultural commodities. Our hearings gathered compelling
evidence that excessive speculation in futures markets was a
significant factor in pushing up oil and agricultural commodity
prices.
Chairman Levin and the Ranking Member, Senator Coburn, have
undertaken an in-depth and exhaustive investigation of
speculation by delving into the inner workings of the wheat
market. I believe that the data and analysis that they have
presented make another compelling case that excessive
speculation has caused our commodity markets to become unmoored
from those who actually make a living using the underlying
commodities, as well as by the consumers who pay the ultimate
price.
I want to just share with the Subcommittee, quickly, an
example that we talked about last spring. It involved a bakery
owner from Maine, Andrew Siegel, who testified before us. He
experienced a truly astonishing increase in the price of the
50,000 pounds of flour that he uses each week. In September
2007, he was paying $7,600 per week for 50,000 pounds of flour.
By February 2008, he was paying $28,000 a week for the same
amount of flour. That obviously jeopardized his ability to
continue in business, and he identified Federal ethanol
policies as well as excessive speculation as the major culprit.
So my point is that the working of these markets have real-
life consequences. They affect not only the pension funds and
university endowments and other institutional investors who are
simply trying to get a better return and seek diversification
of their assets, but they also affect the small baker; they
affect the elderly widow who is heating her home with heating
oil; they affect the farmers; they affect the purchasers of
agricultural and oil commodities.
So to try to combat the effect that speculation has had in
our commodity markets, I have introduced the Commodity
Speculation Reform Act. This bill would limit the percentage of
total contract holdings that non-commercial investors could
maintain in any one commodity market, and the bill would also
close the swaps loophole that currently allows financial
institutions to evade position limits intended to prevent an
investor from cornering a market.
I do want to say that we have made progress in one area
that our Subcommittee has focused on, and that is the lack of
staff and other resources for the Commodity Futures Trading
Commission. Along with Senator Durbin, I serve on the
Subcommittee on Appropriations that has jurisdiction, and I am
pleased to report to the Members of this Subcommittee that we
have provided a 21-percent increase in the budget for the
Commodity Futures Trading Commission. And I think this is going
to help the CFTC to more effectively monitor markets, analyze
the vast amount of complex trading data, and more quickly
respond to problems in the operations of the futures markets.
I personally believe that while I commend the Commission
for looking at regulatory reforms, we also need to legislate in
this area, and I know the Chairman has been a real leader as
well in pursuing legislative reforms over the last few years.
So I am very pleased to be here with you today, and thank
you so much for allowing me to make some comments.
PREPARED OPENING STATEMENT OF SENATOR COLLINS
Mr. Chairman, thank you for your many years of leadership in
exposing excessive speculation, market abuses and manipulation. Last
year, Chairman Lieberman and I held a series of hearings investigating
the skyrocketing price of energy and agricultural commodities. Our
hearings gathered compelling evidence that excessive speculation in
futures markets was a significant factor pushing up oil and
agricultural commodity prices.
Chairman Levin and Ranking Member Coburn have undertaken an in-
depth and exhaustive investigation of speculation by delving into the
inner workings of the wheat market. The data and analysis they have
presented make another compelling case that excessive speculation has
caused our commodity markets to become unmoored from those who actually
make their livelihoods using the underlying commodities, as well as
consumers who pay the ultimate price.
Last spring, Andrew Siegel, the owner of a bakery in Maine,
testified before the full Committee that the dramatic increase in the
price of the 50,000 lbs. of flour that he used per week from September
2007 to February 2008 made it nearly impossible to operate his small
business. He identified federal ethanol policies and excessive
speculation as the major culprits.
Our hearings demonstrated that massive new holdings of commodity
futures by pension funds, university endowments, and other
institutional investors appeared to be driving up prices. These
investors' intentions may be simply to provide good returns and
investment diversification, but many experts believe the size of their
holdings are distorting commodity markets and pushing prices upward.
To combat the effect that speculation has in our oil and
agricultural commodity markets, I have introduced the Commodity
Speculation Reform Act. This bill would limit the percentage of total
contract holdings that non-commercial investors could maintain in any
one commodity market and close the ``swaps loophole'' that currently
allows financial institutions to evade position limits intended to
prevent an investor from cornering a market.
Although commodity market reforms must still be made, Congress has
made important progress addressing another problem our hearings
identified: inadequate funding for the Commodity Futures Trading
Commission (CFTC). The CFTC is responsible for ensuring that the
commodities markets provide an effective mechanism for price discovery
and a means of offsetting price risks. But CFTC's workload has grown
rapidly over the past decade as trading volume increased more than ten-
fold, reaching well over 3.4 billion trades in 2008. Actively traded
contracts have grown by a factor of five--up from 286 in 1998 to 1,521
in 2008.
As the Ranking Member of the Appropriations Subcommittee for
Financial Services, I joined with Chairman Durbin to increase funding
for the CFTC to $177 million--an increase of 10 percent over the
President's fiscal year 2010 request. This funding would provide CFTC
with 21 percent more resources than last fiscal year. This additional
investment will enable the CFTC to more effectively monitor the futures
markets, analyze a vast amount of complex trading data, and more
quickly respond to problems in the operations of the futures markets.
I thank the Chairman and Ranking Member for their work in this
area. It will help make the case for needed reforms.
Senator Levin. Thank you so much, Senator Collins. Senator
Tester.
OPENING STATEMENT OF SENATOR TESTER
Senator Tester. Chairman Levin and Ranking Member Coburn,
thank you very much for having this hearing. This hearing is
liable to be a lot of fun for me. I should explain. I am a
farmer, an actively engaged farmer. Last Sunday I got the
combine ready to go so this weekend we can start harvesting
wheat, hard red wheat.
For years, the neighborhood has been talking about the fact
that the Chicago Board of Trade has been playing poker with our
livelihood. So it is an issue that is very important because,
as Mr. Wands says in his statement, grain is not an asset
class, but--and I paraphrase--food. So it impacts consumers, it
impacts family farmers and farmers of all type; it impacts the
middlemen, too.
I guess I would just say--and if you can answer this in
your opening statement, I will not have to ask: Does supply and
demand exist in a cash market? Or has the futures market
distorted that supply and demand?
What is the overall impact on the cash market of futures
trading, if any?
So, with that, I will save my questions until the end.
Thank you, Mr. Chairman.
Senator Levin. Thank you, Senator Tester. Senator Bennet.
OPENING STATEMENT OF SENATOR BENNET
Senator Bennet. Thank you, Mr. Chairman. I would like to
thank you and the Ranking Member for your leadership on this,
and thank the staff as well for excellent work. The written
materials for this hearing were among the most fascinating I
have read in a long time.
This issue is very important to my State. Farming is risky
business. It is a notoriously thin margin the people in the
food industry have, and it is not a business in which people
enrich themselves or pay themselves large bonuses.
I expect to hear a lot today about the value index traders
have added to commodity markets by increasing liquidity and
shifting risk off of farmers, processors, and end users. And
while this is often true, in practice the written testimony
that we read from traditional market users strongly suggests to
me that it is harder to hedge risk today than it was 10 years
ago. And that is what has my attention about the kinds of
distortions that Chairman Levin talked about.
So, Mr. Chairman, thank you for allowing me to make an
opening statement, and thank you for holding this hearing.
Senator Levin. Thank you so much, Senator Bennet. We
appreciate both of those opening statements, and I am sorry I
did not call on my colleagues for them. I sometimes get
confused as to whether I am in the Armed Services Committee
where our general practice is not to or our Subcommittee here
where our general practice is to. So forgive me for that
oversight.
Now, Mr. Gensler, please.
TESTIMONY OF HON. GARY GENSLER,\1\ CHAIRMAN, COMMODITY FUTURES
TRADING COMMISSION
Mr. Gensler. Thank you, Chairman Levin, Ranking Member
Coburn, Members of the Subcommittee. Thank you for letting me
testify here today. I hope my written testimony can go into the
record, and I will try to summarize as best I can and answer
some of the questions.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Gensler appears in the Appendix
on page 64.
---------------------------------------------------------------------------
Senator Levin. All of the written testimony will be made
part of the record. We will operate under a 10-minute rule here
today, so try to summarize the best you can. When 10 minutes
comes, I think you will be given a light, if that light system
is working. Thank you.
Mr. Gensler. All right. Thank you.
The Subcommittee's report on excessive speculation in the
wheat market is a very important contribution to the whole
market's and the CFTC's understanding of the convergence
problems in the wheat market. The wheat convergence problem is
at the core of the CFTC's mission, that all commodities
contracts, but particularly those tied to physical commodities,
need to be able to be relied upon by producers, farmers, grain
elevator operators, end users, and the bakery owner that the
Senator referred to. Also, for hedging and price discovery, we
seek fair and orderly markets that have a price discovery
function coming together free of manipulation and fraud, but
also free of the burdens of excess speculation.
I would like to start this afternoon with a quick review of
the lack of convergence, which was so well summarized in your
report, but also talk about at least three of the factors that
we think are part of this phenomenon; and then, second, talk a
little bit about what the CFTC has embarked upon most recently,
and some of the hearings that we have coming up on some of
these very related topics; and then, last, talk a little bit
about some of the recommendations in your report.
In terms of the wheat markets themselves and the wheat
convergence, you are absolutely right and your charts were very
helpful. There has been a lack of convergence in the market,
meaning that the futures price and the cash price are not
coming together. And this is at the absolute core of the
markets and has been so for well over a century, since corn and
wheat started on the Chicago Board in the 19th Century. And it
has failed to converge. There is progress based on the
difference with the Toledo price. Your chart was Chicago, but I
apologize I am using a different reference. The convergence
problem got out to over $1 last year. It is now based upon some
of the changes in the contract down to 80 cents in one spot,
and some say it is a little bit better than that. But it is not
satisfactory for the CFTC. We do not think this is enough
progress, and we are going to be monitoring it very closely
into the September contract, which is the next contract to come
up.
Three factors--I mean, many factors have been talked about
in the marketplace, but there are three factors I would like to
focus on today that we believe have contribute to this lack of
convergence: one, the design of the contract itself; two, the
influx, as you put it, of financial investors and index
investors in the market; and, three, what I will call ``large
carry,'' but I will talk about when this marketplace is at
``fully carry.'' That means basically that the prices of the
out or deferred futures contracts are higher than the earlier
months.
In terms of the design of the wheat contract itself, much
has been addressed by your report and by the CME to try to free
up more delivery capacity. If a contract in the futures market
is structured in such a way that the cash market and the
futures market can come together, then it is more likely to
converge. Senator Coburn talked about West Texas intermediate.
That contract has converged, and it has a different contract
design than this contract.
The recent changes by the CBOT in this regard to try to
address the contract effectively is trying to say there is more
places that the wheat can be delivered. They have more than
doubled that to try to say that there are more places wheat can
be delivered into the contract to bring convergence. But as we
have noted, it has not happened yet.
A second factor in the marketplace is what I will call full
carry or large carry, and it seems that there are more problems
in convergence when we get to full carry. What does this mean?
It means that the earlier contracts--there are five contracts
in a year, as the Chairman mentioned. But the earlier contracts
are priced lower than the later-dated contracts. And if it is
attractive to a financial investor to hold that later-dated
contract because they can get more than their cost of money at
the bank, their cost to carry, and more than the storage cost,
then they are more inclined to keep that contract out. At least
the statistics that we look at indicate that the convergence
problem is higher during these full carry periods than
otherwise.
If you look over the last 20 or 30 years, the wheat market
usually is not at full carry, meaning it usually is not
attractive to pay the bank, pay the storage, pay the insurance,
and keep it. We have been in a period of full carry. Is this a
symptom or a cause? Is it a symptom, something that is
occurring because of other factors, possibly the index
investors? Or is it a cause? But it is certainly related to
this.
And then, third, I wanted to mention the relative size of
this market. The Chicago contract is really a very small
market, about $1.5 billion a year annual production, real
farmers producing wheat. It is about $1.5 billion. It is only 2
percent of the global production in wheat. However, this is a
global contract that many investors are looking at and are
looking to try to get exposure, to use a financial word,
``exposure'' to this asset class. But it is real wheat. It is
real farmers. It is only $1.5 billion of production.
So the influx of index investors over this period of time
has effectively taken about half of the long position. About
half of the contracts are owned by effectively index investors.
That is equivalent to about 3 years of annual production. So,
on the shoulders of a very hearty Midwestern crop is placed the
whole global financial markets trying to get exposure to wheat.
And in all of the other markets that we follow--corn, soybean,
crude oil, natural gas--this is the highest ratio with regard
to the market. A little over half of the market is long index
investing, and the ratio to the underlying annual production
being over 3:1 gives you a sense of the magnitude that this
small crop is sort of shouldering. I think all these factors
relate to this lack of convergence.
Now, with regard to the recent changes, as I said, these
recent changes look directionally in the contract to be
positive. We have an agriculture committee that advises us. We
are looking at it very closely. We are going to keep a close
eye on what happens in the September contract. But as I said,
we at the CFTC are not satisfied with where this is.
There are a number of other recommendations in the
marketplace. Some were mentioned. Forced closeout, meaning that
the grain that is in a delivery elevator or on a delivery point
has to be actually delivered out to a future contract, is one
alternative. Another alternative of moving the delivery points
down the Mississippi closer to where the export market is. A
third, which is used in Minneapolis, is called ``cash
settlement.'' All three of these and others we think need to be
considered and further looked at.
We also believe broadly, more broadly to this circumstance,
that we at the Commission should take a close look at all
position limits for commodities of finite supply and look at
the hedge exemptions that have been issued, really starting
back in 1991. We publicly announced we are having hearings. We
are having our first hearing next Tuesday, and then Wednesday,
and then we have a third hearing the following week--where we
have asked for a broad array of experts, probably from both
sides of this debate, to come in and really talk to us about if
we set position limits in the agricultural commodities, ought
we not also set them for energy commodities? If we set them,
shouldn't we really mean them? And how should we look at this
bona fide hedging exemption, which initially, as Congress laid
out and the Chairman noted, was for commercial hedgers, but
after 1991 was widened out for other hedgers?
We are looking forward to hearing from a broad array of
witnesses, but we think that our statute clearly says that we
shall set position limits to protect against the burdens that
may come to markets from excess speculation. I look forward in
our question-and-answer period to get further into that.
We also think we need to work with Congress and work
aggressively with Congress to bring the whole over-the-counter
derivatives marketplace under regulation; that if we only do
this in the futures market, money can travel to other markets.
So not only do we need to bring over-the-counter derivatives
under regulation to better protect the American public and
enhance transparency, but we also need to bring aggregate
position limits to the whole market structure.
Mr. Chairman and this Subcommittee, in terms of the
recommendations in your report, we are looking very closely at
all the recommendations. As it relates to the hedge exemptions
in the agricultural space, whether they be for the swap dealers
or the no-action letters that you referred to, we are looking
at those very closely. As I mentioned, the hearings next week
are going to be very important to us as a Commission. But the
individual exemptions and, particularly the no-action letter
exemptions, say on their face that they were not consistent
with the original intent of what a bona fide hedger is. I mean,
they are financial investors, not directly commercial hedgers.
We certainly would look forward to working with this
Subcommittee about all of the recommendations, but the key
recommendations on the hedge exemptions and no-action letters
we are looking at very closely and will be taking up next week
in our hearing.
I think with that I am out of time and out of testimony.
Senator Levin. Thank you so much, Mr. Gensler.
We will have maybe 10 minutes for each of our questions on
the first round.
In your written testimony, you said the following: ``The
continued lack of convergence in important segments of the
wheat . . .''--this is page 1, third paragraph. ``The continued
lack of convergence in important segments of the wheat market
has significantly diminished the usefulness of the wheat
futures market for commercial hedgers. The reduced ability of
these firms to hedge their price risks increases the cost of
doing business. Ultimately, it is the American consumer who
will bear the burden of these increased costs.''
Am I reading your testimony accurately?
Mr. Gensler. Yes, I believe that convergence is at the core
of our mission for a good reason. It is because we have to have
convergence so that producers and grain elevator operators,
millers, purchasers, and bakeries can hedge their risk, and
then the American public benefits by that.
Senator Levin. All right. And that the inability to hedge
price risks increases the cost of doing business, and
ultimately it is the American consumer who bears that burden?
Mr. Gensler. Yes.
Senator Levin. You have also in your written testimony said
that, ``Hedging in the futures markets only works to the extent
that the price of the commodity in the cash market and the
price of the commodity in the futures market converge as a
futures contract expires.''
I just want to make that a clear statement, and I want to
just make sure you stand by that statement.
Mr. Gensler. I stand by it. It is my written testimony.
Senator Levin. All right. I want to put some focus on that
written testimony.
Now, will the CFTC, as part of its review, look at the
question of whether or not commodity index trading constitutes
excessive speculation in the aggregate so that position limits
should be restored for derivative dealers?
Mr. Gensler. The Commodity Futures Trading Commission is
going to look at position limits across all classes of
speculators. Our statute is set up in such a way that under the
provisions, we are supposed to look at this and only exempt
bona fide hedgers. So we will be looking at it not only for
index investors and exchange-traded funds and exchange-traded
notes, but also for swap dealers and across the broader class
of speculators in financial markets.
Senator Levin. Now, our Exhibit 3 \1\ and your reference to
Toledo both show that the gap between futures and cash prices--
in other words, the basis--has grown dramatically in the last 5
years--on our chart from 13 cents to $1.53. In your testimony,
referring to the Toledo situation, the gap has gone during the
same period from 5 cents to $1.07. Is that correct?
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\1\ See Exhibit No. 3, which appears in the Appendix on page 427.
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Mr. Gensler. That is correct, sir.
Senator Levin. In our case, it is a 13-fold increase in 4
years; with your material from Toledo, it is a 21-fold increase
in 4 years. So even though the dollar amount may be somewhat
less, $1.02, compared to the Chicago futures prices and cash
prices in our report, which is $1.53, the percentage increase
is actually greater in Toledo than it is in Chicago.
Mr. Gensler. Both point to the same problem.
Senator Levin. All right. And that is the problem that we
want to focus on and are glad that you are focusing on. Our
report concludes that the increase in the number of futures
contracts from 30,000 contracts in 2004 to 220,000 contracts in
2008 has created this additional demand for futures contracts
unconnected to and without parallel in the cash market. Would
you agree with that? In other words, there is no increase in
the cash market that equals that increase in the futures
market?
Mr. Gensler. That is correct, sir. The annual production
and the number of millers and bakers and buyers are generally
about the same. That is correct.
Senator Levin. Now, are the demands of the derivative
dealers for futures a significant cause of the increased number
of futures contracts which are out there? We estimate it is
about 45, 50 percent now in the futures market that is demand
by the index investors. Do you have a percentage? Or do you
disagree with our percentage that about half the market is now
those index investors?
Mr. Gensler. We are looking at the same data. About half of
the current market--I mean, it fluctuates, but about half of
the current futures outstanding right now is in this long index
investors or swap dealers who are intermediating for the index
investors.
Senator Levin. As to the issue of price convergence, a
competing theory which has been offered for why there is a lack
of price convergence is that the Chicago wheat contract is
flawed. It makes delivery too difficult, allows holders of
wheat to hang onto wheat too easily, and charges too little for
storage.
Isn't it true that for most of the last 5 years, at least,
the same wheat contract has been in place?
Mr. Gensler. It is true. I do think that some of those
design problems in the wheat contract make this market far more
susceptible to these problems. These problems occur more when
we get into a period of what I earlier called ``full carry'' as
well. So if there was a perfectly blue sky out, everything was
shiny, maybe you would not see as much of a convergence
problem. But there is a problem in the design of the contract
and we get into these periods of full carry, we see this far
more aggravated.
Senator Levin. Do you believe that the dramatic increase in
commodity indexed trading and the futures which are purchased
to hedge against a risk, has played a significant role in the
failure of convergence?
Mr. Gensler. I think, Mr. Chairman, that it is part of the
role.
Senator Levin. Would you say it is a significant part?
Mr. Gensler. I would like to stay with, I think, it is a
contributing factor to this.
Senator Levin. And how much it contributes, are you going
to let us know after some study is completed or what?
Mr. Gensler. Mr. Chairman, I think that we have to work to
get the design of the contract better. We are watching that
very closely. I also believe that we are going to take and use
every authority we have currently, looking at position limits
and hedge exemptions. So we are not actually separately
studying whether it is a 5-percent contributor or a 75-percent
contributor. We do think that in these market environments of
full carry and with this contract design, it has been a
contributing factor.
Separate from that, we think that our authorities are such,
the Congress said in the 1930s that we shall set position
limits, and we should go about that job to help protect against
the burdens that can come from excess speculation.
Senator Levin. And when are you going to be deciding
whether to carry out that mandate--in other words, remove the
exemptions, remove the waivers? When are you going to be making
a decision on whether you will be doing that?
Mr. Gensler. We are going to do it through this process of
the hearings. We have three hearings set for the next 2 weeks,
and then based upon those hearings, we have a Commission
process. There are four of us now on the Commission, and we
will work through that in as expeditious a manner as we can.
Senator Levin. Do you expect that decision will be made by
the fall?
Mr. Gensler. I would hope so, but also I recognize I have
four commissioners and I have to count votes and work through a
very complicated matter. And as you rightly noted, it has been
since 1991 that these exemptions have been in place in many
instances.
Senator Levin. The position limit that you have in effect
prohibits traders from holding more than 6,500 contracts at a
time, and that is designed to prevent excessive speculation.
But the exemptions and the waivers have created some real big
loopholes in that.
In response to our questions, CFTC told us that it had
granted exemptions to four derivative dealers selling swaps,
and it provided no-action letters to two fund managers, which
together would allow these six entities to hold up to 130,000
wheat contract instead of the 39,000 which would be allowed if
that standard limit of 6,500 contracts at any one time had
applied.
Now, in its prepared settlement, the CME tells us that the
number of exemptions is really much larger. They have granted
exemptions to 17 entities selling commodity index swaps and
allowed them to hold up to 413,000 wheat contracts at a time.
They have also said in their prepared statement that, prior to
being approved by the CME, all index traders were required to
receive prior CFTC approval. The CME did not grant any
exemptions to index traders that the CFTC had not already
granted.
So there seems to be a difference there. Your testimony is
that six entities allowed to hold up to 130,000 wheat
contracts, but the CME says 17 entities allowed to hold up to
413,000 wheat contracts, and I am wondering why those numbers
are so different.
Mr. Gensler. Mr. Chairman, I believe that the exemptions
you referred to that are in the CME testimony refers to 15
parties that have various hedge exemptions dating back
sometimes 18 years, and these two no-action letters,
approximating 400,000 contracts in aggregate. I believe that is
an accurate figure.
In the Subcommittee's report, I believe that it is a
slightly narrower question, which was just those granted
explicitly for index investing. So I believe the 130,000 in
your report, which is just a subset of the total 400,000, but I
believe approximately 400,000 is an accurate figure for all
hedge exemptions in this category.
Senator Levin. All right. Again, I would say that in their
prepared statement, prior to being approved by CME, they say
all index traders were required to receive prior CFTC approval.
Mr. Gensler. Well, all hedge exemptions, whether they were
explicitly for index trading or for other reasons, for
agricultural do get CFTC exemptions, as opposed to crude oil
which is done by the exchanges.
Senator Levin. Thank you very much. Dr. Coburn.
Senator Coburn. Isn't the real reason that there is no
problem with price convergence in Cushing, Oklahoma, is because
if you have your name on that barrel of oil, you better be
there in Cushing because delivery is going to happen?
Mr. Gensler. Senator, you are correct that is one of the
design features. It is in essence a forced load-out, so to
speak.
Senator Coburn. So delivery does have a lot to do with some
of this lack of convergence?
Mr. Gensler. Yes.
Senator Coburn. Explain to me the history of why we went
from 5,000 to 6,500 contracts.
Mr. Gensler. Though I was not at the Commission at the
time, the earlier look at this was--setting position limits for
agricultural commodities was a concept to ensure that we have
at least a minimum number of participants in a market and a
diversity of speculators and diversity of points of view. And
so the Commission set them so that no one trade could have more
than 10 percent of the first part of the market, the first
25,000 contracts, and 2.5 percent of the rest.
I believe that back then it was raised from 5,000 to 6,500
just because the overall market had grown. So it was trying to
use percentage limits but adapt it for a larger market.
Senator Coburn. And you testified earlier that this market
really had not grown in terms of the actual wheat coming into
it over the last 10 years, essentially, in terms of raw product
available for the contracts?
Mr. Gensler. Yes, I believe the question was the last few
years. I do not know about the last 10 years.
Senator Coburn. OK, so the last 5 years. So it would seem
to me that if you have the same amount of wheat coming in and
now 50 percent of the contract purchases are by people who are
not commercial--they are not end users, they are not what we
would consider the traditional use of a commodity exchange to
hedge or plan, it would seem to me that there is no question
that there is a direct relationship of index funds and the
long-held positions that would account for some of this non-
convergence. Would you agree with that?
Mr. Gensler. Well, I think they are a contributing factor
to it, and as I said, the CFTC I believe earlier was just
looking that the overall market for the futures--not the cash
but the futures had grown and was trying to keep up with that
in moving that from 5,000 to 6,500.
Senator Coburn. So let us talk about corn then. Has the
overall number of contracts on corn grown?
Mr. Gensler. I would probably have to get back to you on
the exact dates and times on the corn.
Senator Coburn. But there is no question we are planting a
heck of a lot more corn in this country because we, in my
opinion, have foolishly said we are going to use it for
petroleum. But we do have more corn that is out there and more
contracts, right?
Mr. Gensler. I do not have the exact figures in my head as
to the number of contracts----
Senator Coburn. You came prepared for wheat today. I
understand.
Mr. Gensler. I apologize. I can get back to you just on the
number----
Senator Coburn. What I am trying to say is there is corn,
there is soybeans, and there is wheat. You talked about this
$1.5 billion worth of dollars in wheat. I know there is a whole
lot more than that in corn, and we have had a tremendous
stimulation to the production of corn. And so why aren't we
seeing similar problems with corn? Because I know there is
index funds on corn as well.
Mr. Gensler. Right. Senator, I do believe the corn market
and the corn futures market, both cash and futures, are much
larger than wheat. And in wheat, we actually have on the
Chicago market just 20 percent of U.S. production because we
also have Kansas City, which is more related to Oklahoma. We
have Minneapolis, which I think is probably more related to
your home State; whereas, in corn, it has a very different
contract design, much larger market. So index investors are a
much smaller percentage of the open futures interest in corn
just because the corn cash and futures market are much larger.
Senator Coburn. And there is much less of a problem with
convergence in those markets.
Mr. Gensler. There has been some convergence issues, much
smaller in corn or in soybean.
Senator Coburn. Right, OK. How aggressive should Congress
be--and this is opinion, and I am not going to hold you to it,
but I would like to have your opinion because you are sitting
there as the head of the CFTC. How aggressive should we be in
going after this versus letting you under your authority try to
fix this problem?
Mr. Gensler. I think this is a partnership with Congress. I
think that there are many things we can do under our current
authority, but there are many areas where we need help, as
Senator Collins said earlier. We need help with resources, and
we thank you very much for that recent vote in the
Subcommittee. But we also need a great deal of help in terms of
setting aggregate position limits and bringing reform to the
over-the-counter derivatives marketplace.
I think within our current authority we can address
position limits for futures, both in the agricultural and
energy space, and there will be a great deal of debate, and
that is why we are having these hearings. I do think our
authority is very clear that we can do this in the futures
market, but we do need your help to make sure that then money
does not flow elsewhere and that we just push it into a opaque
or offshore market.
Senator Coburn. Right. That is a concern that I have
because I think if we become too restrictive here, the invested
capital goes somewhere else.
Senator Levin mentioned the price of oil and speculation on
that. Is there any doubt in your mind on the effect of index
funds on oil price. And this is for education. I am not trying
to score a point. I am just trying to get educated. Do you
think that they--when we had $140 a barrel----
Mr. Gensler. I think, Senator, that we had a worldwide
asset bubble in a lot of classes of assets. We saw it in the
housing market, and the American people was hurt by that. But
we also had an asset bubble that peaked in June 2008 in many
commodity classes, not just wheat and corn but also oil and
natural gas. That asset bubble had a lot of reasons, but part
of it was financial investors thinking, all right, this is an
asset class, just like I invest in stocks or invest in bonds or
maybe emerging market stocks; we should move X percent into
energy markets.
And so I think it was a contributing factor, but there are
many factors in the overall energy market.
Senator Coburn. Do you think the double-down and double-up
index funds that are double-hedged have any extra contribution
to some of the phenomenon we have seen?
Mr. Gensler. I am not sure I am familiar with the double--
--
Senator Coburn. Well, like DXO, for example. That is one on
oil, which is a double-up. For every point you get up, you get
twice as much. In other words, it is doubly hedged.
Mr. Gensler. Oh, I see, yes.
Senator Coburn. Do you think those have any impact at all
on price swings? Do you think the average investor who is being
told to invest in an index fund has any idea about what the
risks associated with that are?
Mr. Gensler. I think the category that you named is just
part of the broader phenomenon of asset investment that
particularly when there are swings, when there is a swing in
mood.
Senator Coburn. Volatility.
Mr. Gensler [continuing]. That it could bring in. In terms
of the average investor--and certainly this is something, I am
sure, that the SEC and Chair Schapiro and I will look at, too--
I think exchange-traded funds can be a very good product when
well understood by an investor in the stock market or even in
the bond market. As for exchange-traded funds in the commodity
markets, it is still open to me whether investors fully
understand the high fees and the transaction costs because
every one of these funds has to constantly roll their positions
trying to chase to stay even with the underlying assets.
Senator Coburn. A couple of the things that you have
described in your testimony, solutions that might be possible--
compelled load-out, changing delivery location to the Gulf,
adding a new contract which is cash-settled. What are the
potential unintended consequences if you were to do that? Have
you thought through that? And could you discuss those with me?
For example, shifting to the Gulf, what are the unintended
consequences in the market if that were to happen?
Mr. Gensler. Senator, on each one of them, there are pros
and cons and would have to actually be decided by the exchange
themselves rather than the CFTC. We have included them in my
testimony, to highlight there are alternatives. And we have an
agriculture committee that advises us on these as well.
Frankly, there are always winners and losers when you move
a delivery point because the basis starts to shift between the
cash and the futures market. So in that example, you can move
down the Gulf, where most of the export market is and so forth.
Originally the export market was off the Great Lakes if we go
back decades. That is why the delivery points were close to
Chicago. But as more of the export market has moved down the
Mississippi, that is why some people have recommended that. But
there would be some winners and losers.
Senator Coburn. Farmers in Oklahoma during this phenomenon
in 2008 wanted to sell their crops and could not because the
grain elevators could not because everybody was blocked out.
Everybody in agriculture lost. The question is: Who won?
Mr. Gensler. Not the American consumer.
Senator Coburn. The American consumer did not win, but the
American farmer sure as heck did not win either.
Thank you, Mr. Chairman.
Senator Levin. Thank you, Dr. Coburn. Senator Tester.
Senator Tester. Yes, I would like Exhibit 5 put up,\1\ and
I would assume, Mr. Chairman, is this a real example or is it
just a projected example?
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\1\ See Exhibit No. 5, which appears in the Appendix on page 429.
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Senator Levin. Projected.
Senator Tester. It is a projected example.
Senator Levin. Yes.
Senator Tester. OK. Kind of following on what Senator
Coburn had to say, because the previous chart had a triangle
where they converged. They both went down to $3. The futures
fell quicker than the cash price did. Who loses when there is
no convergence?
Mr. Gensler. I think a lot of people lose when there is not
convergence.
Senator Tester. Is it the farmer that loses? Is it the
investor that loses? Who loses?
Mr. Gensler. The farmer and anyone in the physical
commodity chain has less confidence in an ability to hedge
their risk and less confidence in the underlying price
discovery.
Senator Tester. OK. That is assuming the farmer hedges.
Mr. Gensler. It does, but if the farmer does not have
hedging available to them, they are then bearing the risk.
Senator Tester. OK. So I guess what I am asking is, Is it
the investor that loses there, or is it the farmer because this
artificially depresses cash prices?
Mr. Gensler. What it goes to, to at least me, Senator, is
the reliability of the price discovery in the market itself in
that it becomes less reliable. To some farmers, they would say,
rightly, the future is $2 more. Shouldn't I get $2 more for my
blood, sweat, and tears and all my inputs?
Senator Tester. Right.
Mr. Gensler. And that is a very valid question, and some
farmers would not even use the contract because they would say
it does not work.
Senator Tester. OK. And you do not need to bring the
previous one up because you can imagine it. The previous one,
the cash price still went to $3, which I think is an accurate
example at some point in time. So the cash price, which is the
market I sell on, there is no change. The change here is that
the futures contract did not fall down to the price of the cash
price. And so as a farmer who does not hedge, it is still $3 a
bushel. Who loses on that? Somebody has got to lose because if
there is not a loss with convergence, what is the negative?
Mr. Gensler. You are saying when it does converge?
Senator Tester. When it does not converge.
Mr. Gensler. Does not?
Senator Tester. I get it when it converges. When it does
not converge--convergence is where you want to be. If you do
not converge, what is the real problem here? Is there a problem
or is it just a fact we do not converge?
Mr. Gensler. I believe it is a problem because the design
of these contracts are that you can actually deliver, maybe
not--maybe you would be the farmer that did not deliver, but
that some farmer can put it in a vehicle or put it on a barge
and actually physically deliver it.
Senator Tester. So these future contracts are based on real
grain. You are not going to have more future contracts than you
have grain available.
Mr. Gensler. There is supposed to be an ability to deliver
into a futures contract, and even if there were more futures
than there was grain, then anybody who has grain who meets the
certain quality standards can deliver that grain into the
future. You should be able to collect that $2 if you were
willing to transport the grain to the delivery point.
Senator Tester. OK. Let us talk about the design that
controls better, which is one of the solutions you talked
about, and Dr. Coburn said the world is flat, and he is
probably right. If you design your contracts better, what would
stop them from going to Europe or China--I do not know where
these contracts are sold, but I assume they are sold other
places--or Canada, other places than just here where they do
not have as strict of controls? Or are the controls in place in
all those other countries and they do not have this kind of----
Mr. Gensler. We actually have the world's majority share of
trading of futures on wheat contracts. There is Kansas City,
Minneapolis, and Chicago, the three big ones. It is well over
half. I cannot recall the exact statistic.
Senator Tester. Does the convergence problem exist in the
other parts of----
Mr. Gensler. No. The convergence problem is big in Chicago.
One of the things that is unique in Chicago is that market--
which is only about 20 percent of the U.S. production--is the
bellwether. That is the benchmark for a lot of historical
reasons that had to do with Chicago's dominance over Kansas or
Minneapolis in terms of----
Senator Tester. I understand that.
Mr. Gensler [continuing]. Risk capital.
Senator Tester. Can you speak to foreign markets where they
sell futures contracts? Is there a convergence problem there?
Mr. Gensler. No, I am not aware of one, but maybe other
experts could tell you later. I am not aware of a convergence
problem there. It is really in the Chicago Board of Trade
contract.
Senator Tester. OK. What impact, if any, do price supports
from the Federal Government have on futures?
Mr. Gensler. I think that all economic factors--including
price supports from the Federal Government and others--affect
both cash and futures markets.
Senator Tester. I will get to that in a second.
Mr. Gensler. But I will try to address it now. I think that
cash and futures are very linked. They should converge at the
time of expiration. In grain markets as well as oil markets,
the two relate. So any economic factor, whether it is Federal
Government driven or elsewise, will affect both futures and
cash markets, and particularly the outward dated ones.
Senator Tester. Does supply and demand exist in the wheat
markets?
Mr. Gensler. I believe that supply-and-demand factors are
very important in the wheat markets.
Senator Tester. OK. That is good enough. So--and it was
about 16 months ago--the price of wheat--and Senator Coburn was
correct, the elevators would not buy it. But on their board
they had somewhere around $18 to $20 a bushel, depending on
what kind of quality you had. Now that same wheat is probably
worth a third to 40 percent of what it was then.
That difference in the marketplace--and it is a difference
that Senator Collins talked about her baker. I mean, that is
why it went up. It went up at the farm gate, which, quite
frankly, I love, but I do not like to see it go up and down
crazy. We like some consistency. And if the futures market
forced it to go up and was part of the impacts that forced it
to go up--which I believe it was; I think it was much more than
supply and demand in that particular case.
Do you think that the three things that you talked about to
change will solve that problem? And ultimately, in the end,
what impact do you think that those three things will have on
the cash price of wheat to the farm gate?
Mr. Gensler. I think if the exchanges decided to do it by
moving delivery points or forced load-out or this cash-settled
contract, we would have convergence between the cash and
futures market for sure. I think that those three things would
lead to convergence.
The cash prices ultimately are tied, as you said, to
supply-and-demand factors, but related to futures, they would
be somewhere in between. I cannot predict, out of the 80 cents
of lack of convergence now, whether it would be closer to the
current cash price or closer to the current futures price, but
obviously somewhere between that 80-cent spread.
Senator Tester. To be clear, I am not sure the price does
reflect supply and demand, to be clear, because quite honestly
there are a lot of things that--I mean, if you get rain in
Kansas, the price of wheat can drop, and nobody knows that that
is going to increase production an ounce at that point in time.
Mr. Gensler. Right.
Senator Tester. Just for my information--6,500 futures
contracts, how many dollars are in a futures contract? What
kind of money are we talking about?
Mr. Gensler. Well, it is not much because a futures
contract is 5,000 bushels.
Senator Tester. You are talking 325,000 bushels.
Mr. Gensler. Right, times $3 to $4, so it is about $1
million.
Senator Tester. OK. And how many of these folks are out
there trading this? How many traders are out there, do you
know? How many of these 6,500-bushel contracts are out there?
How many people are eligible to trade up to 6,500 futures
contracts?
Mr. Gensler. All the participants in the market are
eligible to trade up to the 6,500 contracts.
Senator Tester. So I could do it if I wanted to.
Mr. Gensler. Yes. There are these exemptions that were
previously referred to. Fifteen parties have hedge exemptions,
and then there are these two no-action letters. I believe only
eight or nine of them are currently over their limits right
now.
Senator Tester. OK. I appreciate your being here, and I
appreciate your answering the questions. I, quite frankly, am
like probably most people; I do not understand this. In fact, I
do not understand it so bad that 22 years ago I got out of the
conventional grain market because I did not want to have to put
puts and calls and all that garbage. I just wanted to raise
wheat and sell it for a reasonable price.
And so I made some conversions in my operation, but what I
will tell you is this: If you can do things in the marketplace
to stop artificially inflating or artificially deflating the
price of wheat--and I am much more concerned about the latter
than the former--you have been successful. Thank you.
Mr. Gensler. Thank you, Senator.
Senator Levin. Thank you, Senator Tester. Senator Collins.
Senator Collins. Thank you, Mr. Chairman.
Senator Tester, are you telling us that it is easier to be
a U.S. Senator than to be a wheat farmer?
Senator Tester. I go back every weekend because it is much
easier to be a farmer. [Laughter.]
Senator Collins. Mr. Gensler, let me ask you a basic
question. Why does the CFTC set position limits for
agricultural products but allow the exchanges to decide whether
or not there should be position limits for energy products,
like oil?
Mr. Gensler. Senator, I am trying to figure that out
myself. It is a lot of history before us. We were originally
set up in the Great Depression, our predecessor was, and we set
agricultural limits. When the oil products started trading in
the late 1970s, there was a deference to the exchanges to do
it. There are some agricultural products, like livestock, where
there is also deference to the exchanges.
What is clear to us in terms of our legislative history, is
that the exchange's only responsibility is to protect against
what is called manipulation and congestion, and they only set
position limits for the last 3 days of the spot month for oil
products.
We have a responsibility under our statute to set position
limits to protect against the burdens that may come from
excessive speculation, this concept of making sure there is a
minimum number of players in a marketplace. So we are going to
look very actively through the hearings and hopefully post the
hearings at possibly setting position limits for energy futures
as well.
Senator Collins. I certainly hope that you will. I do not
think it makes sense--even though I have great respect for the
exchanges--to delegate that authority. It does not make sense
to me that for most agricultural products the Commission is
setting the position limits, but when it comes to energy
products, it is left up to the exchanges.
Do you need legislative authority to set position limits
when it comes to oil products, or do you already have
authority?
Mr. Gensler. I believe that we have ample authority to do
it with regard to futures. As it relates to swaps and over-the-
counter derivatives, we would have to work with Congress to get
that authority.
Senator Collins. Well, I certainly want to give you that
authority.
I want to go back to some testimony you gave. I believe you
said that the index traders, the non-commercial traders,
because of waivers and no-action letters may have held up to 60
percent of the outstanding wheat contracts. Is that accurate?
Did I understand that?
Mr. Gensler. Currently the index investors through swap
dealers have about half of the market. It has ranged from as
low as 35 percent to about 55 percent in the last number of
contracts, but yes.
Senator Collins. So that is a huge influence on the market.
And did that come about because of the exemptions that the
Commission started granting in 1991 to the 6,500 wheat futures
contract limit?
Mr. Gensler. I think it was certainly facilitated by that,
but I think the index investment came about in large part
because there was a change of focus, maybe even philosophy,
about 4 or 5 years ago that commodities were an asset class.
Though some parties used to invest, it dramatically took off
around 2004 and 2005. Your earlier reports have shown this in
the oil markets as well and so forth.
Senator Collins. It is my understanding that the exemptions
permitted four of the swap dealers to exceed that limit, so
instead of being held to 6,500, one was 10,000, one was 17,500,
one was 26,000, one was 53,000, and then there were two no-
action letters that allowed an index-related exchange fund to
hold up to 11,000 contracts, and another fund manager to hold
up to 13,000 wheat futures contracts.
I do not know what the right number is for a position
limit. I do not know whether the recommendation of PSI that it
return to 5,000 is correct or whether 6,500 is correct. And I
would look to the Commission to set the right level.
But I am concerned if index funds are not held to the same
level that everyone else plays by and if there is a difference
in the levels for commercial traders versus non-commercial
traders.
Is there a reason that there should be a different limit?
Mr. Gensler. Again, Senator, I am finding myself in vast
agreement with you and the Chairman on these matters. The
reasoning in the past was that the index investors or the swap
dealers were hedging a financial risk, not necessarily a strict
commercial risk tied to the ownership of grain. They were
hedging a risk of inflation, that if they invested in
commodities, they were somehow hedging their financial risk
rather than a strict product or merchant risk.
Senator Collins. The problem is if it has an impact on the
market as a whole. I understand that the index funds are just
trying to do their fiduciary duty and get as good a return as
possible. But I am concerned about what the impact is of this
massive influx of funds and the number of contracts that are
held by non-commercial traders.
Mr. Gensler. Yes, and, Senator, I think that there is a
very strong logic that whatever position limits we have be
consistently applied across the markets; and whether they are
at 6,500, as you said, or some other number. If we move forward
in the oil space, we should find a consistent approach that
makes these markets work to the benefit of the American public
and ensure that they are fair and orderly and that we do
protect against some burdens of the excess outsized positions.
Senator Collins. Exactly. And that is what I think we
should do, vest in the Commission, if you need additional
authority, to directly set those position limits in both
agricultural futures markets and the energy futures markets,
and then it seems to me they should be the same for all
players. And that is what I would like to encourage you to take
a look at.
I want to switch to another issue. Last year, we had a lot
of discussion about closing what is known as the ``London
loophole,'' and it is my understanding that this is the
loophole that allowed traders to trade U.S. oil futures
contracts on a foreign exchange without facing the same sort of
position limits that they would on an American exchange. And,
typically, I believe this activity took place on ICE in London,
and there were various bills that we introduced to ``close the
London loophole.''
What the Commission did at about that same time is to enter
into an information-sharing agreement with the U.K. regulator,
the Financial Services Authority. But I am told that earlier
this month--it was supposed to allow for better information
sharing, and transparency--but I am told that earlier this
month there was an incident that has caused many people to
question the adequacy of that information-sharing agreement.
Specifically, it is my understanding that earlier this
month PVM Oil Futures Limited, a London-based oil brokerage
firm, admitted that one of its traders had been able to
artificially cause the price of crude oil to spike by 2 percent
in just 1 minute, and that this information was not conveyed
promptly by the FSA, the British regulator, to the Commission.
What is your reaction to that incident?
Mr. Gensler. The incident that you are referring to, I will
call it a ``rogue trader'' at this broker in London on the
Brent crude contract, not on the WTI but the Brent crude
contract. We actually were informed by the FSA within a number
of hours. I do not know if it was a half a day because there
are some time differences and so forth, but I did see that
report in the Financial Times on London. I do not know what it
was referring to because it was not maybe in an hour, but it
was certainly within half a day or so that we knew about it.
I think on the more substantive point, what we were able to
do last year as a Commission is to make sure there is
information sharing. We announced just 2 weeks ago that we are
going to include in our Commitments of Traders report, in our
weekly trading report of all the large trader positions on the
West Texas Intermediate and other linked contracts of ICE. They
are also subject to position limits as of last year. We are now
looking at what other gaps might be remaining between our
current regime with ICE and if there is anything further,
again, to best protect the American public. The information
sharing is going to be pushed out into the Commitments of
Traders report, and they are actually committed and subject on
the linked contracts to be within our position limit regime.
Now, I say ``our position limit regime.'' We have not set
position limits yet. But if we were to set position limits, we
would set it both on NYMEX and the ICE contracts.
Senator Collins. Thank you. Thank you, Mr. Chairman.
Senator Levin. Thank you very much, Senator Collins. And we
would be asking you to let us know what your position is on
that legislation to close the London loophole for the record,
if you would.
Mr. Gensler. I would look forward to doing that.
Senator Levin. I have a few additional questions for you,
and then Senator Collins may have some. Then we will move on to
the next panel.
We recommend in our report that the CFTC phase out all of
the exemptions and waivers that have been granted to commodity
index traders and to reinstate the 6,500 limit for them. Do you
believe that you currently have the authority to take that step
should you decide to do so?
Mr. Gensler. I think that we have the clear authority to do
it as it relates to the two no-action letters. Right on the
face of it, they do not qualify for the bona fide hedge
exemption. As it relates to all of the hedge exemptions, the
other 15, I think that we have the authority, but those were
issued under rules of the Commission, and so it takes a
different process and approach, and----
Senator Levin. It would take a rulemaking?
Mr. Gensler. Probably.
Senator Levin. All right. But you have the authority,
should you decide to issue that rule?
Mr. Gensler. Well, I am going to have to ask my general
counsel--which I should be thanking you for, by the way, that
Dan [Berkovitz] joined us at the Commission.
Senator Levin. He looks very happy where he is at. Can you
find out whether or not he believes that authority exists?
Mr. Gensler. He said he will do it for us, and we will get
back to you. I believe we do have it, but if there are any gaps
in that, we will be asking for your help on that.
Senator Levin. All right. Exchanges typically charge a
transaction fee and a clearing fee for each commodity trade
that takes place on the exchange or is cleared. So, naturally,
the exchanges do not want limits that are going to reduce their
fee income.
Now, is that an economic consideration that you will be
taking into account in your review?
Mr. Gensler. No.
Senator Levin. Finally, let me give you this series of
questions that are linked together. You said that the major
influx of derivative dealers or index traders have contributed
to the failure of convergence. You have told us that this
afternoon.
You have told us, I believe, that the lack of convergence
hurts people who want to hedge, such as elevators. Are you with
me so far?
Mr. Gensler. Yes. That is a ``yes'' to both of those.
Senator Levin. All right. Now, if elevators are hurt,
because they cannot effectively hedge, is it fair to say that
farmers who deal with those elevators would also be hurt?
Mr. Gensler. Yes. I believe that farmers, merchants, anyone
down the production line who cannot hedge is left with the risk
that then they do not have as good an opportunity. This is at
the core of these markets to make sure that farmers, merchants,
elevator operators, and even ultimate purchasers can hedge
their risk and make their own economic choices whether to hedge
or not to hedge.
Senator Levin. All right. Now, some have said that if you
imposed standard position limits on commodity index traders, it
will not be effective because they are going to get around the
limit by setting up new subsidiaries to engage in commodity
index trades. Should you decide to impose the standard position
limits, what is your response to that argument--that you could
not do it if you wanted to, they will just get around it?
Mr. Gensler. I think that they need to be set at the
control or legal entity position. I would also say that we need
to work together on the over-the-counter derivatives
marketplace. If we set them in the futures marketplace, we have
to be cognizant that some trades will just move over there to
the over-the-counter derivatives marketplace.
Senator Levin. Thank you very much.
Mr. Gensler. Thank you, Mr. Chairman. Thank you, Senator
Collins.
Senator Levin. We appreciate very much your testimony.
Thanks.
I would now like to welcome our next panel to this
afternoon's hearing. First, Thomas Coyle, who is the Vice
President and General Manager of Nidera Inc., and the Chairman
of the National Grain and Feed Association.
Hayden Wands, who is the Director of Procurement at Sara
Lee Corporation and Chairman of Commodity and Agriculture
Policy at the American Bakers Association.
Mark Cooper, who is the Director of Research for the
Consumer Federation of America.
And Steven Strongin, Head of the Global Investment Research
Division of Goldman Sachs Group.
We very much welcome you. We appreciate your cooperation.
As you heard before, pursuant to Rule VI, all witnesses who
testify before this Subcommittee are required to be sworn, so
at this time I would ask all of you to please stand and to
raise your right hand. Do you swear that the testimony you will
provide this Subcommittee will be the truth, the whole truth,
and nothing but the truth, so help you, God?
Mr. Coyle. I do.
Mr. Wands. I do.
Mr. Cooper. I do.
Mr. Strongin. I do.
Senator Levin. The timing system is, again, a 10-minute
timing system. I guess we are going to ask for 7 minutes on
this one because we have four witnesses on this panel, so let
me try a 7-minute round for your oral testimony. Your entire
statement will be made part of the record, and we will first
call on Mr. Coyle.
TESTIMONY OF THOMAS COYLE,\1\ VICE PRESIDENT AND GENERAL
MANAGER, CHICAGO AND ILLINOIS RIVER MARKETING LLC, NIDERA,
INC., AND CHAIRMAN, NATIONAL GRAIN AND FEED ASSOCIATION
Mr. Coyle. Thank you, and good afternoon, Chairman Levin. I
appreciate the opportunity to testify today, and I congratulate
you on the recent publication of a very interesting and
insightful report about the U.S. wheat markets. We believe this
extensive report looks at futures markets from a new
perspective. We agree strongly with the key conclusions and
believe it is critical that steps are taken to correct the
imbalances documented in the report.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Coyle appears in the Appendix on
page 71.
---------------------------------------------------------------------------
That said, we believe there are actions that can be taken
to achieve this goal before implementing a restriction on
trading, which is a key recommendation of the report.
As capital invested in agricultural futures has increased
dramatically in recent years, we have become convinced that it
has reduced the effectiveness of futures as a hedging tool for
grain hedgers. The impact has been very dramatic on the Chicago
Board of Trade wheat contract where commodity index traders
hold 56 percent of open interest when spread trades are
excluded. Their share of open interest has remained at a
consistently high level regardless of price and today
represents ownership of more than 160,000 contracts, which is
almost two times the size of the U.S. soft red wheat crop.
These positions held by commodity index traders are
primarily long only, held for extended periods, and are not
responsive to changes in price. We believe this situation, in
which a large portion of the open interest is not for sale at
any price for extended periods, has drained liquidity out of
the contract and contributed to extreme volatility.
We believe strongly that invested capital has been the
significant factor contributing to a disconnect between cash
wheat values and wheat futures prices--a view confirmed in your
report.
Efficient performance of futures markets is critically
important to grain hedgers and producers. Futures markets help
grain hedgers manage price and inventory risk, assist producers
and elevators in valuing their product, and facilitate risk
transfer and marketing opportunities. Performing these key
tasks requires a dependable relationship, convergence between
cash and futures.
Last year's extreme volatility in wheat markets emphasized
this disconnect between cash and futures for soft red wheat.
While cash markets work to seek fair value of the crop,
traditional basis relationships between cash and futures no
longer seemed to apply. The result was an unprecedented
increase in basis risk for grain elevator operators and a
serious concern for the banks that provide their financing. The
imbalance was so acute that basis levels in the interior
increased to more than $2 per bushel to offset the high price
of futures and seek the market value for physical bushels.
As cash and futures diverged, grain hedgers were also
subject to larger and larger margining requirements to maintain
their hedges. The Ag banking system performed well in 2008, but
our industry narrowly escaped a real tragedy in which many
firms could have been forced out of their hedge positions and
out of business. Today, there is a real concern about whether
lenders have the capacity to respond to a repeat situation.
To put this serious situation in perspective, I will share
a case of a very well-run and conservative grain elevator
operation in Michigan. The company projected a $10 million
financing shortfall, but in a 3-week period in early 2008, the
amount grew to $70 million. For a country elevator operation,
this is unheard of. Fortunately, we were able to acquire their
inventories and take assignment of their forward contracts. I
can give you an example of a similar situation in Wisconsin,
where the result was not so fortunate.
The risk of running out of capital was so severe in 2008
that many elevators were forced by financial constraints to
reduce or even eliminate cash forward contract offerings to
producers. Producers were frustrated in their attempts to lock
in favorable pricing opportunities at a time when fuel costs
and other input costs were escalating dramatically. Our
industry's traditional function as a conduit for efficient
pricing for the producer was impaired as the relationship
between cash and futures deteriorated in wheat.
The NGFA has worked actively with the CME for solutions to
these performance problems, and we appreciate the CME Group's
openness and responsiveness to our industry's concerns. We
hoped that markets would correct themselves over time, as
efficient markets tend to do over time. However, the
extraordinary situation in the wheat contract has prevented the
market from correcting in a timely manner.
The CME has just implemented a number of changes to the
wheat contract, and these follow a range of changes that were
made a year ago as well. Included in the recent changes are
seasonal storage rates and the addition of many new delivery
locations. These are significant changes that should have a
positive impact.
We are hopeful that these contract changes will move the
wheat contract back towards convergence, but they may not be
enough. If the current changes do not re-establish convergence,
the CME Group must be prepared to move quickly on additional
measures to complete the task. We believe the CME Group is
committed to restoring contract performance and already has a
concept of variable storage rates under consideration that we
believe holds promise. It will be critically important that the
CFTC move contract improvements through its approval processes
expeditiously.
One important component in the discussion is enhanced
transparency in futures markets. The Commitments of Traders
report changes implemented by the CFTC in early 2007 were very
useful. To further enhance transparency, we recommend that the
Commission add the same level of detail to the lead month--the
contract month with the largest open interest. While this would
not necessarily improve convergence, the information would
assist hedgers in their decisionmaking and would also assist
the Commission and policymakers in evaluating participation of
various types of traders.
Finally, the one area of the report that we are not ready
to embrace is the recommendation to restrict participation by
these new financial participants. Despite the difficult
environment and the imbalance they have created, we would
prefer to see the wheat contract come back into balance with
minimal intervention. However, if contract changes at the CME
are unable to achieve convergence quickly, we recognize that
restrictions may become necessary.
That ends my testimony, and I will be happy to answer any
questions.
Senator Levin. Thank you very much, Mr. Coyle. Mr. Wands.
TESTIMONY OF HAYDEN WANDS,\1\ DIRECTOR OF PROCUREMENT, SARA LEE
CORPORATION, AND CHAIRMAN, COMMODITY AND AGRICULTURAL POLICY,
AMERICAN BAKERS ASSOCIATION
Mr. Wands. I would like to thank the Senate Permanent
Subcommittee on Investigations, and especially Chairman Carl
Levin and Ranking Member Tom Coburn, for holding this
critically important hearing on excessive speculation in the
wheat markets. Again, my name is Hayden Wands. I am Director of
Procurement at Sara Lee. I am here today speaking on behalf of
the American Bakers Association as the Chairman of the American
Bakers Association (ABA) Commodity and Agricultural Policy
Committee.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Wands appears in the Appendix on
page 76.
---------------------------------------------------------------------------
Since the inception of the grain exchange over 150 years
ago, bakers have utilized the exchanges for purchases of
necessary ingredients. These markets enabled farmers to know
what price they can receive for their grains in the coming
months and years and allowed manufacturers to plan for their
businesses' futures by using these same price points as a
component for the food products they produce. This was, and
still should be, the intent of these critical markets.
Unfortunately, the use of these markets has dramatically
changed since 2005. With the influx of index funds, volatility
increased and commodity prices rose to record levels in 2008.
While other supply-and-demand issues also impacted prices in
2008, the record investment of index funds cannot be
overlooked. They are buying agricultural commodities and using
the investments as a new marketable asset class. Grain is not
an asset class, but an ingredient in many basic foodstuffs--
staples of the American diet.
The resulting volatility caused by the influx of index
funds in the wheat market has been dramatic. Historically
speaking, a 10-cent price change in wheat futures contracts was
considered extreme. But today market fluctuations of 30 to 40
cents a day are all too common. Currently, index funds own 196
percent of this year's wheat crop. To put that in perspective,
index funds own 22 percent of the soybean crop and only 13
percent of the corn crop.
The increase in volatility can be seen in the increase of
the monthly trading ranges of wheat. In 2005, the monthly
trading range's average was 39 cents a bushel. In 2008, trading
ranges increased by 461 percent to $1.81 a bushel and are
currently at 269 percent above 2005 levels at $1.05 a bushel.
As long as index funds continue to hold such a large share of
wheat contracts and do not have to operate within limits,
volatility in the markets will continue to harm farmers, food
producers, and American consumers.
The significance of the index funds' positions is increased
due to the finite nature of the supply of the physical wheat.
With accumulation of long-only positions by index funds, the
availability of futures contracts diminishes as they
effectively take contracts out of the available pool. As a
result, the few remaining contracts are price rationed to
reduce the demand for additional purchases of contracts, which
greatly increases volatility.
Bakers cannot escape the impact of index fund activities.
For example, as wheat prices skyrocketed to record highs in
2008, bakers were forced to increase prices for their baked
goods or consider other equally undesirable measures, such as
decreasing staff or shutting down operations entirely.
Members of the ABA testified before Congress regarding this
impact. Frank Formica, owner of Formica Brothers Bakery at
Atlantic City, New Jersey, testified before the House Committee
on Small Business, noting he typically paid $7,000 a week for
flour, but in April 2008, he paid $20,000 a week for the same
amount of flour--a three-fold increase in cost. Many other
bakers shared similar stories about flour cost increases during
this same time period.
The impact of market volatility has driven away smaller but
extremely important market participants. Small businesses,
including bakers, grain elevators, and millers, who cannot
qualify for large credit lines may find it extremely difficult
to participate in the current market. These businesses may look
for alternative hedging mechanisms since hedging in the futures
market may become an activity reserved for companies that carry
extremely large amounts of liquidity and credit.
In addition, the lack of convergence continues to be a
major issue in the futures market. ABA strongly believes that
the lack of convergence exhibited in the market, and
particularly in the Chicago wheat market, is a symptom of the
problem caused by the accumulation of long-only positions by
index funds rather than the root of the problem itself. If
contract limits were placed on index funds, lack of convergence
would be addressed.
Index funds have erroneously been categorized differently
from that of a traditional speculator. They operate under the
auspices of a bona fide commercial hedger. Bona fide commercial
hedgers receive an exemption allowing them to operate without
contract limits and are only limited to the actual amount of
grain they produce, store, or use for feed or food production.
Due to this discrepancy, the index funds currently operate in
the market without encountering any natural or regulatory
limits to the amount of contracts that can be purchased.
ABA strongly believes that index funds must operate within
the confines of a contract limit similar to the limits that
traditional speculators have efficiently operated for many
years. Placing limits on hedge fund activity will be critical
in restoring the integrity of the Chicago wheat contract, as
well as all wheat contracts, and will allow the market to
return to manageable volatility. As such, the ABA fully
supports the Subcommittee's recommendation to phase out
existing wheat waivers for index traders by creating a standard
limit of 6,500 wheat contracts per trader.
Volatility in the markets is a major concern to the baking
industry. Today's volatility represents millions of dollars
daily in undue financial risk. Commodity markets will be able
to once again respond to natural and fundamental supply-and-
demand influences through implementation of contract limits.
I would again like to thank Chairman Levin and Ranking
Member Coburn as well as Members of the Subcommittee for the
opportunity to provide the views of the American Bakers
Association on this important subject. Thank you.
Senator Levin. Thank you so much, Mr. Wands. Mr. Cooper.
TESTIMONY OF MARK COOPER,\1\ DIRECTOR OF RESEARCH, CONSUMER
FEDERATION OF AMERICA
Mr. Cooper. Thank you, Mr. Chairman. In my testimony, I
outline a broad empirical and theoretical explanation of how
excessive speculation has made a major contribution to the
recent gyrations and failures in commodity markets and why they
harm the public. I have made my case with respect to oil and
natural gas, which is what I know best, but based on my reading
of the Subcommittee's analysis of the wheat market, I am
convinced that everything I have said applies to wheat as well.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Cooper appears in the Appendix on
page 87.
---------------------------------------------------------------------------
The debate over excessive speculation is over. The reports
of the Subcommittee on oil, natural gas, and most recently
wheat, as well as my own analyses of oil and natural gas, which
antedated those of the Subcommittee, leave no doubt about the
fact that excessive speculation was an important cause of
problems in commodity markets. The only question on the table
is: What should we do to prevent excessive speculation from
afflicting these markets in the future?''
Good analysis must be the launch point for good policy. A
valid scientific claim that A causes B requires three critical
elements that are in your report:
One, temporal sequence. A must proceed B.
Two, correlation. A and B should move together in the
expected direction.
And, three, explanatory linkage. There needs to be a
mechanism that shows how and why A would move B.
The policy relevance of scientifically valid causal claims
is that policymakers can adopt policies to change A and expect
that the effect will be to change B. In the case of commodity
prices, if it is concluded that excessive speculation is
harmful and it is concluded that the influx of financial
investors--as Mr. Gensler calls them, perhaps to preserve the
good name of speculators--then policies to dampen the influx of
those funds will reduce speculation and improve the outcome for
consumers.
It is absolutely clear that these markets are vital to the
functioning of our economy. The purpose of commodity markets is
to smooth the flow of production in the real economy to allow
farmers and bakers to plan, hedge, and organize their
production. It is absolutely clear that excessive speculation
disrupts this flow. It raises price, creates volatility, drives
these people out of the market, makes it difficult to hedge,
and difficult to plan their production. You have ample evidence
of that.
This Subcommittee's research demonstrates the three
elements of causal explanation. There is no doubt about the
temporal sequence between the influx of funds and the dramatic
increase in price volatility and other aberrations in these
markets. And when you buy a futures contract, as you have
heard, you influence the price. You set the price by holding
that open position at the price you have agreed to. Explanatory
linkages here as well. These financial investors behave
according to a financial logic which treats commodity futures
as assets, not resources. They pay less attention to the
fundamentals of the real economy and more attention to
financial formulas. Index traders just kept pouring money in
and adjusting their portfolios according to the logic of their
index managers. When regulators finally threatened oversight
and when general liquidity in the economy dried up, the
financial investors vacated the market. And lo and behold the
aberrations declined, as you have seen.
Near-perfect correlation like this, with perfect
correlation on the way up and perfect correlation on the way
down, is very rare and very persuasive. The reason the
opponents or critics of your bill--your report cannot offer you
an alternative explanation is that finding that perfect
correlation is very difficult. They just say, well, it must
have been something else because we do not think it was what
you think it was.
But even more importantly, you have heard today the
underlying mechanisms that link the influx of traders to the
problems. Traders profit from rising and volatile prices in a
variety of ways, and they contribute to those outcomes. As
account values rise, excess margins and special allowances
allow traders to take money out of their market or leverage
more trading to keep the upward spiral going. Traders and
exchanges benefit from transaction fees that grow with value
and volume. As long as there is more money coming into these
markets that is willing to bid up the price, the old money
already in the market benefits by staying long.
Of course, it is easy to ensure the inflow of funds when
the managers of those funds also are the advisers to these
financial investors who tell them what to do. It is easier to
sustain the upward spiral of prices when speculators are also
the analysts who release reports hyping the market with reports
of how high prices are and how they will go. When oil was $145
a barrel last year, Wall Street was telling us they had to go
to $200, it would go to $200. I will remind you it is $60 today
after the speculative bubble has burst.
So setting position limits is one step that is absolutely
critical. Defining entities properly is another step. Mis-
defining index traders as commercials was disastrous. They are
not. They do not take delivery. They do not look at the real
market. They only look at their financial performance.
Eliminating conflicts of interest would be extremely
important as well. We have the individual firms on too many
sides of this transaction, and ultimately we really have to
think about the incentives we have given for the
financialization of everything in America as an asset class and
fail to pay enough attention to the real economy. We have to
change the incentives so activity goes back into the real
economy as opposed to these purely financial activities.
Thank you.
Senator Levin. Thank you very much, Mr. Cooper. Mr.
Strongin.
TESTIMONY OF STEVEN H. STRONGIN,\1\ HEAD OF THE GLOBAL
INVESTMENT RESEARCH DIVISION, THE GOLDMAN SACHS GROUP, INC.
Mr. Strongin. Thank you very much, Chairman Levin. We
commend you for your leadership in addressing the factors
affecting the functioning of the commodity markets, which we
view as a critical endeavor. We appreciate the opportunity to
present our thoughts on your report entitled ``Excessive
Speculation in the Wheat Market.'' This is a substantial piece,
which provides a rich and detailed history of the wheat market
and raises critical issues, such as the importance of price
convergence between the cash and futures markets.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Strongin appears in the Appendix
on page 129.
---------------------------------------------------------------------------
I have been involved with the commodity markets for the
last 15 years, having helped construct and manage commodity
index products for much of that time. I served as a member of
the Policy Committee for the Goldman Sach's Group, Inc. (GSCI),
from 1996 to 2007, at which time the index was sold to the S&P,
and I have continued to serve on the Policy Committee
maintained by the S&P.
When we conceived of the GSCI in the early 1990s, we did so
with an eye toward improving liquidity by helping fill the gap
between the large numbers of producers who needed to hedge
their risk and the more limited number of consumers who are
willing to provide those hedges. Since then, passive
investments have become a crucial source of this liquidity.
Capital provided by passive investments is needed to balance
these markets, helping them to fulfill their mission of
allowing producers and consumers to operate more efficiently
and manage their price risk. Yet investors who have provided
this liquidity have been, in our opinion, inappropriately
characterized as speculators with no real economic interest in
these markets.
Most of these investors are, in fact, large-scale asset
allocators who seek to invest in markets in which capital is in
short supply. In doing so, they aim to earn a reasonable long-
run return by improving the underlying economics of the
industry. They, therefore, require real economic justifications
for their investments.
As such, their primary concerns mirror those of the
Subcommittee--namely, what is the realistic capital needed by
these markets? Will investment distort prices and, therefore,
reduce long-run returns? And are these markets liquid enough
not to be distorted by passive capital?
Reflecting these concerns, we have sought to structure the
GSCI so that it provides the greatest possible liquidity with
the least possible market impact from passive investments. We
have regularly assessed whether capital allocated to individual
contracts exceeds the ability of these markets to absorb that
capital.
Turning our attention to the specific issues raised and
recommendations made by the Subcommittee's report. As we
mentioned earlier, this is a substantial piece, but our ongoing
work assessing the liquidity of the GSCI leads us to some
important and differing conclusions from some of those reached
in the report. We outline these key differences here and refer
you to our written testimony for greater detail. We hope our
thoughts prove useful.
First, the Subcommittee report concludes that passive index
investments have been responsible for price volatility in the
CME wheat market. We monitor distortions in the markets by
comparing market performance across contracts. For example,
comparing price performance of Chicago wheat to the performance
of other agricultural markets without passive index
investments. In these markets, we observe similar price moves.
For example, wheat contracts not included in passive indices,
such as Minneapolis wheat, have experienced even greater price
volatility than Chicago wheat. For example, Minneapolis wheat
increased by over 270 percent from January 1, 2007, to the
peak, while wheat prices in the Chicago market rose by 170
percent.
We also monitor this issue by looking at the performance of
commodities that are subject to similar economics as Chicago
wheat, such as rice and oats. Here we also find similar price
patterns. For example, Chicago wheat, and oat prices have
declined by 58 percent and 54 percent, respectively, from the
peak to July 15, 2009. This analysis strongly implies that
passive investments were not the cause of the price distortions
in the Chicago wheat market. Therefore, restrictions in passive
investments would not likely have lessened price volatility.
We would also note that our work on the impact of
speculation shows that non-index speculation has had far more
impact than passive index investments, both per dollar invested
and in total. The reason for this is simple. Index investments
are made slowly and predictably, and contracts are exited well
before settlement. Non-index investments, however, tend to be
strongly correlated with underlying fundamentals, and they tend
to be focused on price levels. Thus, their size is adjusted to
passive index investments, offsetting the effects of those
investments.
Second, the Subcommittee report also concludes that passive
index investments impede price convergence in the Chicago wheat
market, which we believe is a very important issue. However,
our view is that this lack of convergence is driven by flaws in
the design of the futures contracts. Put simply, the high
degree of flexibility of delivery options built into the
Chicago futures contracts and the difficulty of delivery into
those contracts for producers makes the futures more valuable
than the underlying wheat. This is particularly true when the
volatility of cash wheat prices is high. If we compare the
value of these options with the basis volatility raised as a
concern by the Subcommittee, it is clear that contract design
caused much of the basis risk.
The importance of the delivery restrictions in the Chicago
wheat market, pushing up the value of the futures relative to
the cash market is something the Chairman and the Members of
the Subcommittee have already highlighted with respect to the
WTI market. We think the solution parallels suggestions made by
the Subcommittee about oil--namely, expand the number of
delivery sites and generally ease the terms for delivery.
The Subcommittee also suggests that position limits or the
elimination of index investing would reduce volatility in wheat
prices. Given our view that index investing did not cause price
volatility or convergence issues, we do not think there will be
much to gain by implementing such restrictions. However, there
could be significant negative consequences.
First, a large number of index investors are based outside
the United States. Given that there are equivalent contracts
traded on non-U.S. exchanges, much of the activity generated by
these investors would likely migrate offshore.
Second, the proposals currently being suggested would not
actually restrict the aggregate size of the positions taken by
U.S. investors. Instead, these positions would likely be
splintered across multiple brokers, multiple ETFs, and multiple
mutual funds so that each of these vehicles would remain below
individual position limits. In stressful market conditions,
such a splintering would likely lead to even greater market
volatility as the sale of large positions tends to destabilize
markets under stress. When these positions are in the hands of
a single party or a small numbers of parties, their orderly
sale is possible. However, when these positions are in the
hands of multiple dealers or funds, each dealer or fund manager
is incentivized to sell quick before the others do. This is
especially true for dealers running smaller trading books or
for fund managers who compete for the best relative
performance. For these participants, a faster sale is best.
This can lead to disorderly markets and extreme volatility.
Thus, it is our view that splintering existing positions could
lead to greater price volatility and increase the likelihood
that prices overshoot underlying fundamentals.
Attempts to regulate volatility have rarely, if ever,
succeeded. Yet they often have unintended and significant
consequences. Therefore, as we look to the future, we think the
harmful volatility that has been observed in markets in the
recent past begs us to focus on the question of which types of
market rules and oversights allow participants to best manage
their risk at a reasonable cost.
Thank you for taking the time to listen to our prepared
remarks, and we look forward to answering your questions.
Senator Levin. Well, thank you all very much for your
testimony. Let us try a 10-minute round here for this first
round of questions.
Let us start with you, Mr. Coyle. Your testimony as fairly
dramaticly that producers have been frustrated, cash forward
contracts were impaired because the relationship between cash
and futures markets deteriorated. You are hopeful that contract
changes will help, but you said that they may not be enough.
And you indicated that if the contracts do not achieve
convergence quickly, intervention may be necessary. I am trying
to summarize your testimony.
How quickly do they need to converge in order to meet your
standard?
Mr. Coyle. I would say that we would want them to converge
this crop year. It takes a certain amount of time to make these
changes, but there have been changes implemented already, and I
would expect that sometime between September's expiration and
December, the CME can roll out their next change in contract
specs if they do not see that the current changes have had the
impact.
While the changes they have made are very positive, there
is a certain amount of skepticism that it will actually achieve
the goal. Certainly it is in the right direction.
Senator Levin. Do you believe that the dramatic increase in
the investment by the index traders, contributed to the lack of
convergence?
Mr. Coyle. No, sir. I believe it caused it, singlehandedly.
Not a contribution. It is the single issue that has caused the
problem in convergence.
Senator Levin. You go even beyond the CFTC director.
Mr. Coyle. Yes, sir.
Senator Levin. Mr. Wands, do you believe that the huge
investment by index traders is either a contributing, major, or
exclusive reason why we have seen convergence fail?
Mr. Wands. Well, we feel that their presence and their size
has exacerbated the problem dramatically.
Senator Levin. Is it fair to say that you feel it is a
major factor in the failure of convergence?
Mr. Wands. It is a predominant factor, yes.
Senator Levin. All right. Mr. Cooper.
Mr. Cooper. I actually agree with Mr. Gensler, and
certainly when I testified in oil--fundamentals matter and so
they do play a role here. But excessive speculation matters,
too. That is the important point, and as I saw it, at least $40
a barrel, it grew to $65 or $70 a barrel. That is enough money
to get your attention even if fundamentals count for something
else.
Senator Levin. All right. Now, Mr. Strongin, do you agree
with Mr. Coyle and Mr. Wands that the influx of these index
funds into the market, which now results in them controlling
about 50 percent of the market, is either the factor, as Mr.
Coyle said, in terms of the loss of convergence or a principal
factor, as Mr. Wands said, in terms of loss of convergence?
Would you agree with that?
Mr. Strongin. I would not, Mr. Chairman, respectfully.
Senator Levin. That is all right. Now let us get to the
point that the contract was not significantly changed until
recently. Is that not true, Mr. Strongin?
Mr. Strongin. It has not changed effectively at all.
Senator Levin. And yet we see this huge spike in the
futures contracts and the huge gap that now exists between
futures and cash prices. And the contract did not cause that,
presumably, or the shortfalls in the contract did not cause
that, because that spike took place while the contract did not
change.
Mr. Strongin. The problem is that there is an embedded
option inside of the futures contract for below-market cost of
storage, meaning that if you own the futures contract, you can
avoid paying the full price of storage and store wheat.
Senator Levin. That was true for 5 years, wasn't it?
Mr. Strongin. Absolutely true.
Senator Levin. All right. So that has not changed.
Mr. Strongin. No. But the value of it did change. There are
two things that drive the value of it: one, the cost of
storage; and, two, the volatility of the prices around that
storage. And as we saw in many markets in this environment, the
volatility picked up a lot, and options increase in value when
volatility goes up.
Mr. Gensler referred to this--the cost of storage went up
because the grain elevators were full, and the shadow price of
the grain elevator storage, because they had run out of space,
was even greater. As a result, that value of below-market
storage went way up. So the option value went way up, and that
is effectively what we are applauding when we look at the
basis.
Senator Levin. Let me go back now to Mr. Coyle. Can you
comment on storage prices and whether or not the change in
storage prices can explain this increase in the basis gap?
Mr. Coyle. Yes, sir, I can explain it, and I would say with
certainty that is not the case. Yes, storage costs have gone
up, and, yes, I will agree with Mr. Strongin that there is a
contract design issue. I will even agree that storage changes,
like the variable storage rate the CME will next consider, can
have an impact. And recent changes in the storage rates are a
move in the right direction.
However, at this moment we have a record number of shipping
certificates that have been issued against the----
Senator Levin. I am sorry. Record number of----
Mr. Coyle. Shipping certificates. That is a representation
of inventories. A record number of shipping certificates issued
against the CME futures contract, and that has not solved the
problem. And we do not have consumers taking ownership of those
shipping certificates and those inventories because they think
it is a good value because it is a cheaper source of cash.
Senator Levin. Well, I am not sure I understand your
explanation as to why you disagree that the storage cost shift
cannot explain this increase in the gap between futures and
cash prices. Try it again.
Mr. Coyle. While it may be more costly to build today, we
have always had the issue of storage, of full carry. In the
current environment, we have a market that is full carry, which
means it currently pays all of the costs of storage, even the
higher Board of Trade storage rates, and we still have a 70-
cents-per-bushel convergence problem.
To suggest that the optionality of owning the Board of
Trade Futures, which means it gives you the opportunity to have
the access to this cheaper storage, is a reason that the
futures price is higher is just something that we would
disagree with.
Mr. Cooper. Chairman Levin, I would take another tack at
his answer because you focused on the cost of storage and the
value of storage, but he hypothesized an increase in
volatility. I would submit, as I do in my testimony, that the
presence of these indexed funds is the cause of that increase
in volatility. So at that level, the answer is too cute by a
half.
Senator Levin. All right. Let me go back to Mr. Coyle. You
are something of an expert, I believe, in terms of elevators,
are you not?
Mr. Coyle. Yes, sir.
Senator Levin. What is your expertise?
Mr. Coyle. Well, I manage a business that happens to own
the largest Board of Trade delivery elevator for corn, beans,
and wheat, so we specialize in grain storage, and I am a member
of the grain industry, so I have spent most of my career
managing grain elevators and the risk around those.
Senator Levin. Now, when there is a lack of convergence,
who is hurt? You are an expert. Tell us.
Mr. Coyle. The first person that is hurt is the grain
elevator operator because, by definition, the convergence
problem increases the amount of basis risk. A grain elevator
that buys grain, whether it is Michigan, Wisconsin, Ohio,
Indiana, anywhere, buys grain assuming a relative relationship
to the Board of Trade, finds that as the prices go up after he
bought the grain that the basis is lower 6 months down the road
after he has paid the cost to store that grain. So that would
be the initial cost.
But then there are the other factors. The farmer, of
course, is then hurt, because as the grain elevator operator
has more risk, he has to pass that along to the farm community
through lower basis levels. In addition, as you have got this
basis convergence problem, banks are more concerned about
loaning money, so your cost of money goes up. And maybe you
even get into a situation, as we did last year, where there is
a concern that there is not enough capital at all, and so you
stop offering bids to farmers.
I would say in the last 12 months, probably the single
biggest person harmed would be the farmer, because, in fact,
the grain elevators stopped bidding for grain 6 months out, 7
months out, 8 months out because they were afraid they would
not have the capital to margin their accounts.
Now, this is not 100 percent of the problem with
convergence. The fact is, in 2008 when the market rallied,
there were a number of issues that made the market higher. It
could be the biofuels, the fight for acreage. There are a
number of things that made the market go higher, but this
convergence problem does put at risk the availability of
capital to run your business.
Senator Levin. In addition to the elevator operator and the
farmer, tell us about the consumer. How does that get passed
on?
Mr. Coyle. We have heard the comments that costs have gone
up, and I think that is true, but again, a number of issues
have had an impact on why the price of commodities is higher.
But the whole issue of convergence is that the basis levels
actually went lower to offset the price of higher futures.
While the price of futures went from $5 to $6, basis levels
went from $.25 under to a $1.25 under. In reality, the price
that the farmer was selling grain at, and the price that the
consumer was paying, was the fair value for wheat, right? So I
wouldn't argue that there was so much volatility and so much
unknown and so much risk that overall prices were higher. But,
by and large, the higher futures price was offset by a drop in
the basis.
Senator Levin. Finally, let me just ask one question of
Goldman Sachs' representative Mr. Strongin. You have indicated
you don't think there should be position limits on index
traders at all, is that correct?
Mr. Strongin. I said that position limits would likely not
fix this problem, sir.
Senator Levin. Do you oppose position limits on index
traders?
Mr. Strongin. I don't think it will help the problem, and
yes, I do oppose it.
Senator Levin. How about other types of folks who you have
said have a bigger impact on futures than index traders. Should
anyone have limits?
Mr. Strongin. Actually, we have argued generally that the
position limits should be on speculative positions. They should
be generally applied. And probably the most important notion
would be what some of our internal people would sort of say,
look to, look through, which is putting the position limits on
the end users.
Senator Levin. Would that include your customers?
Mr. Strongin. That would include our customers.
Senator Levin. So you do believe there should be position
limits on index traders' customers?
Mr. Strongin. Yes. We don't think--index positions on the
index traders or the hedgers--not going through all the terms
that were used to describe the hedgers here--really is about
form of investment as opposed to actual position limits, where
if you put it on the customers, it is actually changing the
position limits and the positions.
Senator Levin. Let me just be real clear. You believe there
should be position limits on the customers of index traders?
Mr. Strongin. Yes.
Senator Levin. Thanks. Thank you. Dr. Coburn.
Senator Coburn. Let me ask this question of Mr. Coyle. What
has the price convergence problem been for wheat at
Minneapolis?
Mr. Coyle. We have not had a convergence problem in the
Minneapolis----
Senator Coburn. Do they trade index funds there?
Mr. Coyle. I understand very little.
Senator Coburn. Very little. What about Kansas City?
Mr. Coyle. They do have index trading there. I am not aware
that there is a convergence problem in Kansas City.
Senator Coburn. So they have index trading there, but they
don't have a convergence problem yet. Our position on the
Chicago Exchange is that there is a correlation between index
trading and price convergence.
Mr. Coyle. Yes.
Senator Coburn. Explain that to me.
Mr. Coyle. Yes, sir. I think the issue is magnitude. We
have a large index trading in soybean and corn futures, as
well. But as Mr. Wands mentioned, you have a much smaller
share, all right, on a relative basis if you compare that----
Senator Coburn. You mean less than the 50 percent?
Mr. Coyle. Yes, less than 50 percent, 35 percent, let us
say, rather than 55 percent. But also, if you look at the
magnitude of the crop, as Mr. Wands said, the open interest
held by index funds is 13 percent of the size of the corn crop.
In the case of soybeans, it is 22 percent. In the case of
wheat, it is 195 percent. It has just out-balanced the size of
the crop relative to size of the market participation.
In reality, that has actually gotten worse, because last
year, we had a huge production in the United States, 600
million bushels of wheat. This year, it is only 414 million
bushels. So in reality, a year ago, that same number was 145
percent. This year, it is 195 percent. It is a function of just
too much for the market to handle.
Senator Coburn. OK. Does the higher volume generated by the
commercial index traders actually increase liquidity or
decrease liquidity, in your opinion?
Mr. Coyle. In my opinion, it decreases liquidity. It
actually increases volume, but it actually drains liquidity. If
you have half of the trade that won't sell, then when the next
buyer wants to buy, they can only buy half of what is out
there.
Senator Coburn. Well, but they do sell. They just roll.
Mr. Coyle. They roll, but they buy and sell it the same
day.
Senator Coburn. Yes.
Mr. Coyle. If we have a business, someone wants to buy U.S.
wheat and the price rallies 50 cents a bushel and the farmer
has already sold most of what he wants to sell this month,
where does the next sale come from? At this point, it comes
from a speculator that wants to be short because it is not
going to come from the primary long. So in a normal market
situation for----
Senator Coburn. Fifty percent of the primary long?
Mr. Coyle. Yes, sir.
Senator Coburn. OK, and not--some primary longs will sell,
but 50 percent of them won't.
Mr. Coyle. Fifty percent of the open interest--56 percent
of the actual flat price related open interest is held by
somebody that will not respond to short-term economics.
Senator Coburn. OK. So let me go to you, Mr. Strongin. Have
I got this right, that I could actually buy an index fund, pay
the storage cost, and net about 4 percent versus the cost of my
money, if nothing changed in terms of the price of the contract
and I just kept rolling the contract?
Mr. Strongin. I am not sure I understand the question
because there is not a free lunch in that process.
Senator Coburn. Well, if, in fact, I can get half of one
percent for my money in a CD and there is minimal price changes
but high volatility on contracts for wheat and I can make money
off the storage differential, can I not, in fact, markedly
increase my yield versus the half-a-percent or quarter percent
that I could get for my money somewhere else?
Mr. Strongin. So the index investor is only holding the
investments while it is in futures and in no time takes
advantage of the reduced storage costs.
Senator Coburn. So who makes the money off that?
Mr. Strongin. Well, the person who takes advantage of it is
the person who needs wheat in the future and this way can store
it below market cost and they are simply willing to pay for
that. In other words, you can think about it almost like
prepaying a discount card. If I can get below-market storage
for a certain period of time, I am willing to pay up front for
that below-market storage. So they are not actually going to
make money. They are just paying money now. That is why the
futures costs more than the cash because they get the right to
store it at below-market rates after that.
Senator Coburn. OK. Does everybody at the table agree that
there needs to be changes in the contract on wheat?
Mr. Coyle. I certainly do.
Senator Coburn. Mr. Cooper.
Mr. Cooper. I am--as I understand it, it will help, but it
won't solve the problem.
Senator Coburn. What would solve the problem?
Mr. Cooper. I think more aggressive position limits,
conflict of interest properly classifying traders, a whole
series of steps are necessary to reform this and other
commodity markets.
Senator Coburn. If you do all those things, won't this
money go to an overseas market?
Mr. Cooper. Well, as Mr. Gensler pointed out, the United
States is a big place and people want to be able to trade in
U.S. instruments and U.S. markets. So there will be plenty of
liquidity in this market. There is excess liquidity in a
certain sense in this market, this huge influx of capital. So
it is my belief that the United States can, in fact, establish
a set of rules that will make for an orderly market and plenty
of traders will come here to preserve the liquidity of this
market.
Senator Coburn. So you think there is minimal risk for us
of losing capital in this country by making these changes?
Mr. Cooper. I think there is a minimal risk because of the
commodities that people want to trade in. West Texas
intermediate is a U.S. commodity designated for trade in U.S.
markets, and as I understand it, foreign boards of trade
desperately want to be able to trade that stuff. So if they
refuse to conform to our statutes and they can't trade here,
they will basically be unimportant. So this is a big place and
I firmly believe that if we organize our markets, we won't be
at a competitive disadvantage.
The interesting thing is that when you talk about London
and Paris, those governments are looking very carefully at much
more strict regulation than we actually are. If you look at the
conversation, they are sort of pulling the Americans along. So
it may well be that those markets are not going to be less
regulated and therefore more attractive. I think the world is
moving towards a much higher level of prudential regulation in
all the major exchanges.
Senator Coburn. Mr. Strongin, your comments on that?
Mr. Strongin. Different activities have different mobility.
In this case, you have a large number of non-U.S. investors who
have easy access to non-U.S. futures contracts. That activity
would exit the United States very easily.
I do not think it would imperil the functioning of our
futures markets because we do have in truth large domestic
individuals on both sides. But it would reduce the liquidity.
It would shift--it could potentially source the center point of
liquidity away from the U.S. markets in some cases. It is a
cautionary tale, but German bonds now trade almost entirely out
of London for similar reasons. So it is not automatic that the
activity will be here. But the United States is an important
enough market that it would continue to function afterwards.
Senator Coburn. But there is some risk?
Mr. Strongin. Of significant activity leaving.
Senator Coburn. Yes. OK. Mr. Coyle, you don't think that we
ought to eliminate index trading on the Chicago Board, is that
correct?
Mr. Coyle. At this time, that is correct.
Senator Coburn. Can you foresee a time when you would think
that should be done and why?
Mr. Coyle. Well, I would say first, we would like to see
the results of the current major changes in the Chicago Board
of Trade's contract, allow them to come out with a next set of
changes if they are necessary, and I would say a good
percentage of people think that probably will be required to
see if that can restore the balance and it converges as the
market needs.
If by some chance that can't be done, then we don't rule
out that something will need to be done, some other step. But I
would question whether or not a change in the limits or the
exemptions would actually solve the problem.
First, and it relates to a comment that was made earlier,
the current limits of 6,500 contracts, that is $162 million.
Any individual in this room could actually buy 8 percent of the
U.S. wheat crop with the current limits. That is one comment.
Second, if capital really wants to deploy in commodities,
then there are a lot of ways even within those limits that you
can restructure your product so that you can find other ways to
deploy that capital. It is certainly not as efficient as they
can do it today in a futures market where the costs of
execution are so cheap, you don't have counterparty risk, and
so on. But it can be done.
And then there is the risk of the unintended consequences,
I would say particularly if, in fact, this same capital decided
that it wanted to pursue the physical market instead of the
futures market. We would fix the convergence problem
immediately because they would actually buy the physical
bushels which they are not buying today. But if they did that,
we would lose a lot of transparency that we enjoy today because
we get to see those contracts.
My company has been contacted by two funds in the last
month alone, looking for ways to now participate in the
physical market. You can imagine if 195 percent of the
equivalent of the crop is owned today in futures contracts,
what would happen if they wanted to buy physical bushels? You
would have the physical price go up, all right. The convergence
problem would go away. You wouldn't know where it is at and we
actually would have an inflation problem and millers, when they
needed to buy the wheat, couldn't buy it.
Senator Coburn. Mr. Strongin, what do you attribute the
tremendous increase in activity in index funds, especially as
related to commodities? I know they are everywhere, but what do
you attribute that to? Is that an increased sophistication of
the American investor? Is that the American investor who is
wanting to get hard commodities to hedge against the future?
What is the overall reason why we are seeing this tremendous
shift to index funds, away from specific assets?
Mr. Strongin. Part of it has to do with the way the word
``fundamentals'' has been used here. Fundamentals can apply to
two very different things. One of them, which is the way it is
normally used in this conversation, is today's cash market. How
much supply, how much demand, what price balances at.
The second has to do with investment. Today when investors
look at the global economy, when they look at the emergence of
China, when they look at the emergence of India, when they look
at what is going on in Latin America, they see incredible need
to invest and they believe that they need prices that are high
enough to drive that investment and they believe that commodity
prices will rise and commodity industries will become more
valuable.
And so across the board, whether it is in terms of
investing in Brazil or investing in emerging markets in
general, investing in oil companies or in hard commodities, you
see investors trying to protect themselves from the pressures
that will create. As you look at the necessary demand of the
emerging market, you want to have exposure to basic
commodities. You want to have exposure to energy. You want to
have exposure to grains. You want to have exposure to all raw
materials.
And they have increased their exposure to those things in
all ways, whether it be through index participation or direct
equity investing. You can see it in the percent of the S&P made
up by commodity companies. You can see it in how the emerging
markets are priced relative to the developed markets. People
want that exposure because when they look at future demand and
the need to invest, they see that as a key central element of a
forward economy and forward fundamentals.
Senator Coburn. Right, and that is why we see China doing
what they are doing.
Mr. Strongin. That is right. And to the point I made
earlier, they are actually buying physical commodities and that
has a lot more power to move prices than these futures do.
Senator Coburn. OK.
Mr. Cooper. Senator, could I try a slightly different
answer? And I don't disagree with the fact that physical assets
are important, I believe, in market fundamentals. But the other
thing we have done is we have distorted the incentives in our
country to over-reward short-term financial rewards and under-
reward long-term investment in the real economy through a long
series of policies that make it easier to make money by
flipping things than by investing in hard physical assets, and
I mentioned that in my testimony. It is really important that
we rejigger those incentives so that you can make as much money
with a real good investment in the real economy as you can by
getting into short-term financial gains.
Senator Coburn. The difference there being is that if you
are doing it in the short-term, you are going pay regular,
ordinary income tax rates versus capital gains rates, which is
a disincentive to flip----
Mr. Cooper. And we used to have taxes on short-term capital
gains which----
Senator Coburn. We still do. They are at your ordinary
income tax rate.
Mr. Cooper. And they were higher before and they were
lowered and that has helped this shift.
Senator Coburn. I guess your testimony would be that we
should raise taxes?
Mr. Cooper. I actually believe we should raise taxes to
promote investment in the real economy, absolutely.
Senator Levin. Mr. Wands, who is representing the American
Bakers Association, you have testified that contract limits
need to be restored, I believe. Is that correct?
Mr. Wands. Yes. Well, what we are asking for is that index
funds be termed speculators and they fall under those type of
contract limits.
Senator Levin. All right, and that there not be waivers or
exemptions?
Mr. Wands. Correct.
Senator Levin. And what is the effect of lack of
convergence on bakers?
Mr. Wands. Well, it is not--as Mr. Coyle commented, I think
it is more significant on the production side, starting with
the country elevator and then falling to the farmer. The lack
of convergence on the bakery side, typically, we lock in our
prices fairly well in advance so we don't have the
ramifications that the production side does. One thing that can
hurt us is if we lock in our basis, which we can do from time
to time, and the market rallies severely, as Mr. Coyle said,
then the basis falls significantly and then we will be--if you
chose to lock in your basis early, you will be at a significant
disadvantage to, say, your competition who waited. So there is
volatility for us in the basis depending on when we lock it in.
But again, it is more on the production side and the producer
side.
Senator Levin. But the volatility in the basis has had an
effect on you. What is the cause for this huge fluctuation in
the price of flour?
Mr. Wands. Well, if you break down the price of flour, for
the most part, when we look at our risks, about 70 percent of
the defined risk, roughly about 70 percent of the risk that you
can hedge either by buying basis or selling mill feed or buying
futures price, 70 percent of it is related to futures. It is
not an exact correlation, but as futures rise, that is going to
reflect significantly on the flour price, more than the basis
or the other ingredients in pricing flour.
Senator Levin. So the price of futures going up is what has
that effect?
Mr. Wands. Significant, yes.
Senator Levin. And we have shown the correlation between
the huge influx of money from the index funds to the increase
in the futures prices.
Mr. Wands. Yes. That is correct. Somebody earlier asked
about Kansas City. While the index funds do have a presence in
Kansas City, it is significantly less than in Chicago, and you
have to remember that while you are dealing with a 400 to 450
million bushel soft wheat crop, you are looking at a billion
bushel hard wheat crop--hopefully bigger this year--so their
presence in Kansas City, while it is there, is not nearly as
significant as Chicago and you don't have the convergence
problem in Kansas City.
Senator Levin. It is not nearly as significant as in
Chicago----
Mr. Wands. Correct.
Senator Levin. You are all set. Thank you very much. You
have been a fine panel. We appreciate your presence.
We will now call on our third panel. Finally, we call on
Charles Carey, Vice Chairman of the CME Group. Thank you for
your patience, first of all, Mr. Carey.
The CME Group was formed by the recent merger of the
Chicago Mercantile Exchange (CME), and the Chicago Board of
Trade and the New York Mercantile Exchange.
Pursuant to Rule 6, all of our witnesses must be sworn, so
we would ask you now to stand and raise your right hand.
Do you swear that the testimony that you will be giving
will be the truth, the whole truth, and nothing but the truth,
so help you, God?
Mr. Carey. I do.
Senator Coburn. Mr. Chairman, I would like to just insert a
comment into the record from our last panel. I got to thinking
what the Consumer Federation of America said. He wanted to
raise taxes to spur investment. I am not sure many people
recognize that as a legitimate economic policy.
Senator Levin. OK, thank you.
Under our timing system today, Mr. Carey, we ask that you
limit your oral testimony to 10 minutes, but your entire
statement will be made part of the record. Please proceed.
TESTIMONY OF CHARLES P. CAREY,\1\ VICE CHAIRMAN, CME GROUP,
CHICAGO, ILLINOIS
Mr. Carey. I am Charles P. Carey, Vice Chairman of the CME
Group. Thank you, Chairman Levin and Ranking Member Coburn, for
inviting us to testify today, respecting the June 24, 2009
staff report titled, ``Excessive Speculation in the Wheat
Market.''
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\1\ The prepared statement of Mr. Carey appears in the Appendix on
page 143.
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I was Chairman of the Chicago Board of Trade, the home of
the soft red winter wheat market, prior to the merger that
created CME Group. I trade wheat, corn, and other agricultural
products and I am the point person on the Board of Directors
for dealing with the grain markets. I deal with the concerns
respecting the impact of index traders on our markets expressed
by our members and the agriculture industry and have been
directly involved in the Chicago Board of Trade's ongoing
efforts to modify the wheat contract to assure better
convergence.
As you are aware, some of our commercial customers believe
that index trading may be having unwarranted impacts on our
wheat market. We responded to these concerns by arranging for
an independent analysis of this thesis across grain markets. We
also cooperated with the others conducting such studies and we
analyzed all the studies of this subject that preceded the
report prepared by this Subcommittee.
None of the relevant studies that we dealt with supported
the conclusion that index traders or swap dealer participation
in our markets was the cause of volatility, high commodity
prices, or lack of convergence. Indeed, in our corn and soybean
markets, there have been no significant convergence issues even
though there is substantial participation in those markets by
index traders and swap dealers. Despite the clear conclusions
of these independent professional studies and our own
experience in other grain markets, the concerns remain.
Those who are not professional statisticians or economists
continue to focus on the confluence of unexplained price
behavior in the large share of open interests held by non-
commercial participants. It is difficult to ignore that
coincidence and some of our traders and customers assumed that
there was a strong chance that the two were connected.
Professional economists and statisticians explained to us,
however, that it was necessary to show causation, not just
coincidence, and that it is a common logical error to attribute
cause based only on correlation.
Many had hoped that this Subcommittee study and report
would add new evidence and clarify the relationship between
index trading and the lack of convergence or any other
unexplained price effect. The Chicago Board of Trade is
absolutely committed to solving the convergence problem. Like
you, we would have been pleased if the report had provided a
simple explanation and easily deployed solution. Unfortunately,
economists and the informed critical response to the report
tell us that it does not explain the lack of convergence and
that its proposed solutions are more likely to be harmful to
the functioning of our markets than helpful.
You asked us to answer five questions and to discuss the
Subcommittee's recent staff report, ``Excessive Speculation in
the Wheat Market.'' My written testimony provides extensive,
well documented and reliable answers to those questions. I
don't intend to use this limited time to restate those answers.
Instead, I want to focus on our efforts to deal with the likely
causes of the lack of convergence between futures prices for
soft red winter wheat and the reported bid prices for that
commodity.
In our efforts to eliminate this divergence, we share a
common goal with the Subcommittee. We differ only on how to get
there. We absolutely agree with the Subcommittee's concern that
the lack of convergence impairs the value of our market and it
needs to be corrected. We share the concern of knowledgeable
economists who have examined this market and who have carefully
reviewed the Subcommittee's report that the evidence produced
in support of the conclusion that index traders are the
principal cause of the lack of convergence and persistent
contango has not been validated by any of the statistical
measures that are accepted by experts in the field. Our
analysis of some of the report's conclusions is included in my
written testimony.
In particular, we are concerned with the measure of cash
price used to calculate the value of the cash and futures
converge. Neither the price of the actual transactions nor the
midpoint of actual purchases and sales was used. Instead, the
report used a national average price as represented by the
MGEX-DTN soft red winter wheat index as the cash market price.
Basis was then calculated as a futures price minus the MGEX
software index price. At best, this number represents the price
at which some elevators, most outside the delivery area, claim
they were prepared to purchase during a relevant period.
The choice of this measure does not reflect true delivery
market economics. Economists and traders expect futures prices
to converge to the price of the cheapest to deliver based on
location and grade. There is no theory supporting the implicit
claim that futures prices will converge to the average
hypothetical offer prices in multiple locations.
We are concerned that the report's focus of blame on index
traders and speculators directs attention away from appropriate
efforts to identify any structural problems with the contract
specification and impairs our ongoing efforts to cure the
problem by fixing those terms. Assigning responsibility for the
convergence problem to the wrong cause will only delay its
solution and may result in greater problems.
The Chicago Board of Trade has implemented very significant
changes to the delivery specifications of the soft red wheat
contract. We have acted in accordance with our obligations
under the CEA respecting the timing of changes to enumerated
futures contracts with open interests and have attempted to
take account of the suggestions of all segments of the industry
to whom this contract is important. We have also implemented
the changes in an orderly fashion so that we will have
sufficient time to judge their effectiveness and so that we do
not in haste overshoot the market and risk damaging the
liquidity on which the market users depend.
We have authorized a wide-ranging addition of delivery
points and facilities. We had 58 new locations for delivery
that will provide an additional 90 million bushels of capacity
on the Ohio and Mississippi Rivers and in a 12-county area of
Northwest Ohio. We expect that this will relieve any congestion
issues that prevented arbitrage from driving the convergence
within historic ranges and better align our delivery locations
with the primary flow of soft red winter wheat in the domestic
cash market into the New Orleans Gulf for export. Similar
changes made to the corn and soybean contracts in 2000 greatly
enhanced the performance of these contracts and we expect
similar results from these changes in the wheat contract. We
have also implemented seasonal storage rate adjustments that
are intended to incent shorts who want deliverable wheat or who
can acquire deliverable wheat to make delivery when the basis
moves to unjustifiable differentials.
The higher futures storage rate during the July-December
period reflects the higher seasonal storage rates in the cash
market when wheat that has just been harvested competes with
the upcoming corn and soybean harvests for storage space and
will allow wider carrying charges, if needed, throughout the
country elevator system for producers with on-farm storage. The
higher futures storage charges will also encourage buyers who
stand for delivery and must pay the storage rate to the seller
to either load out or redeliver the wheat, both of which will
enhance convergence.
On September 1, a reduced level of allowable vomitoxin will
be implemented which will convert the contract from a feed-
grade wheat contract to a human consumption grade. We expect
that this change will have a positive impact on convergence for
the following reasons. The estimated cash market discount for
wheat with four parts per million of vomitoxin is 12 cents per
bushel and that differential will be applied to four parts per
million wheat delivered against futures contracts. Par delivery
will require no more than three parts per million of vomitoxin,
which is expected to improve the cash futures relationship by
12 cents per bushel.
The second reason is the industry standard for vomitoxin in
the domestic milling and export markets is two parts per
million, and we will implement this level in delivery
specifications for the futures contract in September 2011, with
three parts per million remaining deliverable at a 12-cent--
actually, it is a 12-cent discount, at four parts per million,
a 24-cent discount. This final change in the quality
specifications for the wheat contract will align our par
quality specifications with industry standards while providing
the flexibility to deliver lower-quality wheat at a significant
discount when higher quality is not available.
It is possible that we will see some significant
improvement in contract performance by mid-September and
certainly by the end of the year. The basis has already
strengthened. It was $2 last year, and as we have seen, the
charts have gotten better, and as we checked it today, it was
somewhere around 80 under, so----
If the results fail to meet our expectations, we have
additional modifications at the ready and are prepared to
continue to modify the contract or to introduce a new contract
to provide a safe and effective environment to permit producers
and users to hedge their needs and to provide effective price
discovery to the remainder of the market. We respectfully
suggest that this is a more reasoned approach than the one that
discourages market participation with the attendant risk of
damage to market liquidity.
We are committed to dealing effectively with the lack of
convergence by attacking the structural problems regarding
specifications in delivery. In this regard, we are aligned with
the report's recommendations. We do not, however, believe that
restrictions on index traders beyond those that we already
impose are anything but a distraction from our efforts.
Thank you very much.
Senator Levin. Thank you very much, Mr. Carey.
Exhibit 1,\1\ which has been put up, and I think it is in
your book, if we could put that up again, tracks the number of
wheat futures contracts purchased by commodity index traders
from 2004 to 2009. We obtained this data from the CFTC on index
trading in the wheat market. It shows that commodity index
traders have dramatically increased their purchase of wheat
futures from 30,000 contracts in 2004 to 220,000 in 2009. You
have indicated in your prepared statement that from 2006 to the
present, the percentage of long open interests held by
commodity index traders fluctuated between 51 percent in
January 2006, to 32 percent in October 2006. The most recent
data for July indicates the percentage to be 46 percent.
---------------------------------------------------------------------------
\1\ See Exhibit No. 1, which appears in the Appendix on page 425.
---------------------------------------------------------------------------
So I am correct, I believe, that you agree as a factual
matter that since 2006, commodity index traders have typically
held almost half of the outstanding wheat futures contracts on
the Chicago Exchange, is that correct?
Mr. Carey. Yes, sir.
Senator Levin. Would you also agree that prior to 2004,
commodity index trading was not a big factor on the Chicago
wheat futures exchange?
Mr. Carey. Commodity index trading?
Senator Levin. Yes, in the Chicago wheat futures prior to
2004.
Mr. Carey. It has experienced tremendous growth. We didn't
have numbers prior to 2006, but according to these numbers,
yes.
Senator Levin. So you would agree that it was not a big
factor prior to 2004?
Mr. Carey. But it existed. To what extent, I don't have the
numbers.
Senator Levin. Do you believe that it was a big factor
prior to 2004?
Mr. Carey. No. I would expect that this chart is pretty
accurate.
Senator Levin. All right. Now, Exhibit 3 \2\ is a chart
showing the basis or the gap between the futures and the cash
prices for wheat on the expiration date for each of the five
wheat contracts that were traded on the Chicago Exchange from
2005 to 2008. We obtained the final futures prices on the last
day of each contract, then went to data compiled by the U.S.
Department of Agriculture showing what the cash price was on
that day in Chicago. The U.S. Department of Agriculture
obtained its cash prices by asking elevators in the Chicago
area to report their bids to buy wheat on that day. It then
produced a daily price report which is available on its
website.
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\2\ See Exhibit No. 3, which appears in the Appendix on page 427.
---------------------------------------------------------------------------
Would you agree that this data shows a significant jump in
the basis since 2006?
Mr. Carey. Absolutely. Yes. There has been a lack of
convergence, which is what we are trying to tackle right now.
Senator Levin. Right. So you would agree that the basis,
the price gap, is larger than has been historically the case,
is that correct?
Mr. Carey. Yes, sir.
Senator Levin. Now, were there changes in the contract that
were made between 2004 and 2009?
Mr. Carey. Well, recent vomitoxin changes. I can't remember
the first time we went from five to four, but now we are going
from four to three. But most of the changes have just taken
place in the most recent July contract, sir.
Senator Levin. And yet we see this major change in the
basis while the same contract was in effect, is that correct?
Mr. Carey. Yes, sir.
Senator Levin. So it can't be that the contract is the
problem, or can it be?
Mr. Carey. Well, it could be.
Senator Levin. You say no expert says, for instance, that
the increase in investment by index traders is the cause of the
lack of convergence. You said no expert says that.
Mr. Carey. According to the reports that we had, that might
have been a factor. But the reports----
Senator Levin. It might have been a factor?
Mr. Carey. Some part of it. I think there were other
factors, too, as we recognize.
Senator Levin. How big a factor is it?
Mr. Carey. I would leave that to the experts, and they
didn't----
Senator Levin. Well, we had three experts here today. We
had one who was the head of the Commodity Futures Trading
Commission. He said it is a factor. We then had the elevator
operators representative here, Mr. Coyle, who said it is
probably the principal, almost the exclusive factor. I would
think he is an expert. He knows firsthand. Mr. Wands, of
American Bakers, says that it was a significant factor in the
lack of convergence. Are they not experts? They are out there
every day in that area of work, are they not?
Mr. Carey. They have an opinion.
Senator Levin. Is it an expert opinion?
Mr. Carey. From where they stand.
Senator Levin. And they say that index trading is either
exclusively or significantly a cause, or in the case of Mr.
Gensler, a cause in the lack of convergence. And would you
agree with any of those experts?
Mr. Carey. Would I agree with them? Not exclusively. We all
have our own opinion. I would say that we have a global
benchmark and a correlation of 92 to 96 percent to world wheat
prices and that is why we are tackling the design issues, sir.
And I think that they have the opinion that this is the cause,
the sole cause. I believe that there are a fair amount of
causes to create this lack of convergence.
Half of the conversation I heard today revolved around
volatility versus lack of convergence. So there were a lot of
issues being discussed and debated here, but this is a cause
and I would agree with Mr. Gensler. It is a cause, but it is
not exclusive.
Senator Levin. Well, the only one who said it was
exclusive, and that was the first time he testified, the first
time around, was Mr. Coyle, and then he said a principal cause.
I don't think anyone ended up saying it is an exclusive cause.
Is it a significant cause, and if it is a significant cause, it
seems to me something has got to be done about it. We have
either got to get position limits back on, or we have to do
something which addresses that part of the cause.
Now, if the contract is part of the cause, you will find
out pretty soon, won't you?
Mr. Carey. Yes, sir----
Senator Levin. By when?
Mr. Carey. Well, we heard Mr. Coyle, who is more involved
in the cash grain market on a daily basis than I am, but he
said that he would give it a couple of delivery cycles, and the
vomitoxin change is September, and he said that he would hope
within this cycle. And I think we are working hand-in-hand with
him. We have a similar interest. Convergence is key and
providing contracts that work is key. I think we also share the
same opinion that just limiting participation without examining
the problem and fixing the problem. If that is the sole
problem, fine. But we want to remain a problem as the global
benchmark for commodity trading and we want this convergence
issue to be handled properly.
Senator Levin. Well, I am glad to hear you acknowledge at
least that it is a contributing factor. That is more than we
got out of your printed testimony. Where in your printed
testimony does it say it is a contributing factor to the lack
of convergence?
Mr. Carey. I don't believe it says that in there.
[Pause.]
Senator Levin. You said you should know whether any changes
in the contract have a significant effect on the convergence
issue and that would be two cycles, is that what you said?
Mr. Carey. Well, we are coming up to one more change in
September, sir, and we hope to get through. I would echo Mr.
Coyle's remarks that we need to go through a couple of delivery
cycles, whether it is December or whether it is March delivery.
By that time, we should know whether or not this convergence is
going to take place with these changes or if additional changes
need to be put in. I believe that our staff is working with the
Commission and with the industry to come up with a solution
that does place convergence at the forefront of our changes.
Senator Levin. Thank you very much. I will be right back.
Mr. Carey. Thank you.
Senator Coburn [presiding]. Well, thank you for your
testimony. You all do want the convergence problem fixed?
Mr. Carey. Absolutely.
Senator Coburn. It is not really good for your business in
the long term, is it?
Mr. Carey. That is correct, Senator.
Senator Coburn. It is not good for you as a market, either,
is it?
Mr. Carey. That is correct, Senator.
Senator Coburn. So people are going to start loading out of
CME to somewhere else in the world if it is not fixed?
Mr. Carey. Yes, they will find another place. I think I
disagree with ideas in some of the testimony that took place,
that money can't move offshore or to different marketplaces.
Today, the Dalian Exchange in China trades more volume than the
Chicago Board of Trade soybean, meal, or oil contract. Today,
there is a wheat contract in France. I know that there has been
rhetoric that says they are going to suppress this excess
speculation, but I will tell you to look at what is going on in
the world. There was an article Monday morning that oil trading
is growing in London, where it doesn't agree necessarily with
what we are hearing. So yes, I think that we have to recognize
that we live in a global environment.
Senator Coburn. And do you agree with the gentleman from
Goldman Sachs that people are looking to invest in assets that
are hedging for their future and that one of the things they
invest in is commodities, both hard and soft commodities? Do
you agree with that?
Mr. Carey. Clearly. These swaps dealers exemptions, most of
them aren't speculators. Most of them are investors.
Senator Coburn. OK. I am going to ask you a question as if
I were a purist. If we have commodity markets, we have
producers and we have end users, but those markets never really
function very well unless you have a certain amount of
speculators in there to help create the market, is that
correct?
Mr. Carey. That is true.
Senator Coburn. There is no question, and you would agree,
I believe, that we have had a marked increase in activity in
speculation, either through index funds or some other way, on
these commodities?
Mr. Carey. We have had an increase in interest. We have had
some extreme volatility, and we have had some very unusual
situations that I think were a big part of the cause of this
volatility, whether it is the ethanol you cited or whether
these investors are coming into this area for a reason.
Senator Coburn. Right. And so the gentleman from Goldman
Sachs said he didn't think position limits would solve the
problem for a couple of reasons, and extrapolating from what he
said, do you agree that there will be just more firms with
smaller positions that will do more of that that ultimately
might have more damage to the market, as he testified?
Mr. Carey. Yes, they could. The fact of the matter is, I am
more concerned about exporting a business that we have here in
the United States than I am about how people are going to try
to access these markets.
Senator Coburn. But if they can't access your market, then
you are not going to be able to export that business.
Mr. Carey. No, what I am saying is that somebody takes the
business offshore----
Senator Coburn. Yes.
Mr. Carey [continuing]. Or into a dark pool of liquidity,
because investors will seek the marketplace and that asset
class in a different way.
Senator Coburn. The profitability--and I want to be fair in
this hearing and I think the Chairman will agree--there is no
question you have a financial interest in increased trading on
your exchange, correct?
Mr. Carey. Yes, but we also know that if there is no
integrity in our contracts, that people will leave. But yes,
clearly, we get paid fees per contract.
Senator Coburn. So if we eliminated tomorrow all index
trading on your exchange, that would have a significant
financial impact on CME Group?
Mr. Carey. Yes. Clearly, it could have some impact.
Senator Coburn. I want to go back to this idea of
convergence. I believe it is multifaceted and I believe index
does have something to do with it. Tell me what you think are
the factors that you have identified, as consistent with your
testimony and anything else, that you think are the factors
that have led to this lack of convergence. What do you think is
going on? I mean, just flat out, what are all the variables
that you all see, and after you tell me those, what do you see
as the answer to fixing that? I know we have talked about the
timing of getting some of these changes through, modifying the
contract, but what do you see as the factors that are
influencing this lack of convergence?
Mr. Carey. Well, I think that it was identified here by
both Mr. Gensler and Mr. Coyle, in that it is a 400-million-
bushel crop this year. It was 600 million bushels last year.
Yet people come here because it is the global benchmark and it
is where the liquidity is and so people want to trade it. And
so we correlate more to a world price than we do to a Toledo or
Chicago price, and so this is what is causing some problems in
the marketplace and we have to find a way to bring convergence.
But we are a financial services company and we want to be able
to offer these products to the world. We want to remain the
global benchmarks for grain trade.
Senator Coburn. So one of the problems, you think, is
because you are trying to----
Mr. Carey. It is contract design, sir, and deliveries and
these are the things that we are addressing.
Senator Coburn. And you told the Chairman that you think
that index does have some influence on it?
Mr. Carey. Yes, obviously, we have----
Senator Coburn. So we have contract design and index
trading. What else?
Mr. Carey. Well, I think you had a period of tremendous
volatility caused by factors, not just by speculation, but by
world factors. The fact that last year, the wheat stocks in the
world were the lowest since 1947, with the Marshall Plan. They
were 60-year lows, and that is when President Truman was pretty
angry about trading in wheat futures. So I think that and the
ethanol pulling acres out of wheat production, I think we
suddenly ran into the worst planting conditions last spring on
top of energy prices, and we don't control our destiny when it
comes to energy prices in this country, so that while there can
be short-term surpluses and we look at these reserves, the
world knows that we don't produce enough oil to support our
demand over time.
So there are a lot of factors that would lead people into
investing, but overall, there is still a fair amount of open
interest in these contracts by these investors that we are
talking about, and yet the markets have come down dramatically.
So I think the markets are trying to work.
Senator Coburn. Well, I would add a fifth factor. One of
the reasons people were investing there is fear of not getting
a return in other investment vehicles.
Mr. Carey. Absolutely.
Senator Coburn. So we listed five, fear of not getting a
return, ethanol and the shift in plantable acres, decreased
worldwide reserves, index trading, and contract design. So are
you all looking at the things that you can have a play on, the
things that you can influence, do you have a plan, a design so
that you address the ones that you can address?
Mr. Carey. We do, and we are meeting with the Commission
and we are meeting with the industry and it goes back over a
year. When we went to $12 or $13 a bushel in Chicago and
farmers couldn't sell, part of it was the banking crisis at the
time. It was a strain that nobody had anticipated----
Senator Coburn. And the elevators couldn't borrow money to
buy wheat.
Mr. Carey. That is right, and suddenly the only place
people could go was to the futures market, and so they went to
the futures market. And so it took some time for this to settle
down. But the market has converged. It has come back
dramatically and we hope the changes will have it converge even
better so that these kinds of problems don't exist for these
short hedges, because there was----
Senator Coburn. Well, I was just going to point to that
chart. We are now--I think the end one on the last contract
there was what, $1.20?
Mr. Carey. It could be. It was a little bit--yes, it is
between----
Senator Coburn. And we are now, 80 cents?
Mr. Carey. Yes, somewhere between 80 and a dollar.
Senator Coburn. What would you expect the convergence to be
after these next two contracts close?
Mr. Carey. I would hope it would be well under 50 cents or
40 cents. You have to take into account that prices are higher,
the dollar is lower. All these things have taken place since
these charts were first drawn.
Senator Coburn. But that is still historically very high,
you agree?
Mr. Carey. It is high, but the price went up because of the
other problems. The fact that it is fulfilling, I think whoever
said that should look at the price of grains today, and look at
the price of corn today, because it is not a self-fulfilling
investment. It just is not.
Senator Coburn. All right. Mr. Chairman, thank you. I
appreciate this hearing.
Senator Levin [presiding]. Thank you very much, Dr. Coburn.
Let me close by thanking, first of all, our last witness.
Mr. Carey, thank you for coming.
We obviously have identified a problem here that the amount
of index trading has created volatility, has contributed, many
think in a major way, but has contributed, I think, by
consensus to the lack of price convergence. That has had a very
negative effect on a whole host of people. It doesn't have to
be that way.
The CFTC has told us they are going to review these
exemptions and waivers to see if they should be eliminated, and
we look forward to that. That is going to happen hopefully in
the next few months. Also in the next few months, you are going
to redesign or continue to redesign your contract, Mr. Carey.
We are going to see what kind of effect that has.
And then there is the financial reform bill which is in
Congress to regulate over-the-counter and derivative dealers,
and that all is going to come into play in the fall, as well.
So a lot of things are going to converge. There may not be
price convergence in your wheat market, but there is going to
be convergence of a lot of factors in the fall.
We may have additional questions for our witnesses, so we
will keep the record open for 10 days.
We very much appreciate the cooperation of all of our
witnesses and the hearing is adjourned.
[Whereupon, at 5:49 p.m., the Subcommittee was adjourned.]
A P P E N D I X
----------
PREPARED STATEMENT OF SENATOR MCCASKILL
I want to first thank the Subcommittee for their truly
comprehensive investigation and leadership on this issue. This
report hits home. For over the past year I have received
numerous calls from farmers across Missouri who are seeing
their livelihoods fade. Now volatility is nothing new in Ag
markets, and frankly investment interest in the wheat markets
does help to provide price discovery. But from 2007 to 2008 the
average daily basis for wheat traded on the Kansas City Board
of Trade rose by 51 cents per bushel. During 2008, the maximum
basis reached to about 90 cents. The market just doesn't seem
to be working and as the gap between futures and cash prices
widens, the chances for our farmers to get a fair shake quickly
declines. In this economy, price convergence is essential.
My farmers are telling me that right now the price is
holding at $5.42 a bushel--the grain elevator takes $1.20 and
minus the cost of seed, fertilizer, rent, etc., they're losing
about $50 per acre. Multiply that by 3,000 acres or so and
that's a lot of money. The negative basis was much higher this
time last year--as much as $ 2.29. What it boils down to is
that this money comes out of the pocket of the farmer. It's
been likened to just giving away a third of your crop.
As long as the negative basis keeps increasing, so does a
farmer's ability to turn a profit. Ultimately, if the vicious
cycle continues, farmers are saying they just won't plant as
much wheat. That's clearly not a solution any of us are looking
for.
I know I don't have to remind my colleagues it's not just a
Missouri issue. Price convergence is critical for farmers to
stop treading water everywhere.
I implore the CFTC to work with the relevant exchanges and
find sensible ways to establish convergence in the market.
Missouri farmers need help and they need it quickly. With
escalating input prices and the extreme volatility in these
markets our farmers must have a quick solution.
Thank you again for the Subcommittee's work. I'll be
interested in hearing from the panels on how we can come to a
compromise to restore natural order to these markets.
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