Spot Cheese Market: Market Oversight Has Increased, but Concerns
Remain about Potential Manipulation (21-JUN-07, GAO-07-707).
The Chicago Mercantile Exchange (CME) is home to the spot cheddar
cheese market, which impacts the prices of virtually all cheese
traded in the United States, producer milk prices, and milk
futures contracts. The spot cheese market, formerly the National
Cheese Exchange (NCE) in Wisconsin, has been and continues to be
the subject of concerns about price manipulation. GAO was asked
to examine (1) the market's structure and ongoing concerns about
price manipulation; (2) market oversight and efforts to address
potential manipulation; and (3) how the market impacts federal
milk pricing. In response, GAO compared the markets at NCE and
CME, analyzed trading data, collected information about the
Commodity Futures Trading Commission's (CFTC) oversight, and met
with industry participants, academics, and agency officials.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-07-707
ACCNO: A71232
TITLE: Spot Cheese Market: Market Oversight Has Increased, but
Concerns Remain about Potential Manipulation
DATE: 06/21/2007
SUBJECT: Agricultural industry
Commodity sales
Comparative analysis
Dairy industry
Dairy products
Monitoring
Prices and pricing
Pricing surveys
Trade regulation
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GAO-07-707
* [1]Results in Brief
* [2]Background
* [3]Certain Structure and Operations of CME Spot Cheese Market A
* [4]Some Operational Aspects of the CME Spot Cheese Market Resem
* [5]Thinness of the CME Spot Cheese Market, Combined with Other
* [6]CFTC and CME Provide Increased Oversight of the CME Spot Che
* [7]CFTC Monitors Trading Activity to Identify and Address Poten
* [8]CME Conducts Daily Surveillance of the CME Spot Cheese Marke
* [9]The USDA Survey of Cheddar Cheese Prices Largely Duplicates
* [10]Conclusions
* [11]Recommendations for Executive Action
* [12]Agency Comments and Our Evaluation
* [13]Appendix I: Scope and Methodology
* [14]Appendix II: Comments from the Department of Agriculture
* [15]Appendix III: GAO Contact and Staff Acknowledgments
* [16]GAO contact
* [17]Staff Acknowledgments
* [18]Order by Mail or Phone
Report to Congressional Requesters
United States Government Accountability Office
GAO
June 2007
SPOT CHEESE MARKET
Market Oversight Has Increased, but Concerns Remain about Potential
Manipulation
Spot Cheese Market Spot Cheese Market
GAO-07-707
Contents
Letter 1
Results in Brief 3
Background 5
Certain Structure and Operations of CME Spot Cheese Market Are Similar to
Those of NCE, and Certain Characteristics Result in Ongoing Concerns about
the Potential for Price Manipulation 8
CFTC and CME Provide Increased Oversight of the CME Spot Cheese Market 13
The USDA Survey of Cheddar Cheese Prices Largely Duplicates CME Cheese
Prices and Introduces a Time Lag into Some Milk Prices 22
Conclusions 27
Recommendations for Executive Action 28
Agency Comments and Our Evaluation 29
Appendix I Scope and Methodology 33
Appendix II Comments from the Department of Agriculture 35
Appendix III GAO Contact and Staff Acknowledgments 39
Table
Table 1: Average of Number of Transactions Per Trading Session by Barrel
and Block on the CME Spot Cheese Market, 1997-2006 10
Figures
Figure 1: Percentage of Trading, by Largest Block and Barrel Market
Participants, January 1, 1999, to February 2, 2007 11
Figure 2: Influence of CME Spot Cheese Market Prices on Class III Milk
Pricing 23
Figure 3: CME Spot Cheese Market and NASS Cheese Survey Block Cheese
Prices 26
Abbreviations
AMS Agricultural Marketing Service
CEA Commodity Exchange Act
CFTC Commodity Futures Trading Commission
CME Chicago Mercantile Exchange
DMO Division of Market Oversight
DOJ Department of Justice
FMMO federal milk marketing order
FTC Federal Trade Commission
NASS National Agricultural Statistical Service
NCE National Cheese Exchange
SRO self-regulatory organization
USDA U.S. Department of Agriculture
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separately.
United States Government Accountability Office
Washington, DC 20548
June 21, 2007
Congressional Requesters
For almost a decade, the Chicago Mercantile Exchange (CME) has been home
to a spot cheese market, which impacts the prices of virtually all cheese
traded in the United States as well as producer milk prices and milk
futures contracts.1 This spot cheese market moved to CME in 1997 amid
allegations of price manipulation on the National Cheese Exchange (NCE) in
Green Bay, Wisconsin. 2 NCE was a nonprofit corporation established to be
a market where surplus supplies of cheese were bought and sold, and cheese
had been traded there for over two decades. Cheese producers generally use
CME spot cheese market prices to set their sales prices, according to
industry participants. In turn, minimum prices for raw farm milk bought by
many cheese manufacturers are set using a U.S. Department of Agriculture
(USDA) pricing formula whose most significant commodity component is the
weekly average of cheddar cheese prices drawn from a survey of large
cheese manufacturing plants.3 Futures contracts for milk used in
manufacturing cheese are also settled at expiration using the minimum
price for milk as determined by the pricing formula.
Some industry participants had hoped that moving the spot cheese market
would alleviate concerns about price manipulation. But during the last few
years, trade press articles have described ongoing concerns in the dairy
industry about potential price manipulation at the CME spot cheese market
and the potential effects on certain milk prices. Generally, price
manipulation is any planned operation, transaction, or practice that
intends to and causes or maintains an artificial price--that is, a price
that is higher or lower than it would have been if it had reflected the
forces of supply and demand. The Commodity Futures Trading Commission
(CFTC), which provides regulatory oversight of the CME because of its
futures markets and also has responsibility for enforcing a federal
prohibition against manipulating the price of any commodity in interstate
commerce, has received several complaints or allegations from industry
participants and others about price manipulation on the CME spot cheese
market. These concerns generally involve observed price fluctuations on
the CME spot cheese market and the possibility that these fluctuations
might result in prices that are too high or too low. Such concerns have
revived suspicions about the market's susceptibility to manipulation and
raised questions about the effectiveness of the move from NCE in
addressing concerns about price manipulation and whether there is
sufficient regulatory oversight of the market.
1A futures contract is a highly standardized (as to quantity, quality,
location, and delivery terms) agreement to buy or sell a commodity for
delivery in the future and has as its purpose the offset or management of
risk rather than actual delivery of a product.
2Spot markets involve the payment and physical delivery of a commodity.
For cheese, this occurred at the NCE and now at the CME, in addition to
other locations. References to spot markets in this report are only
referring to the market at either NCE or CME.
3See 7 C.F.R. S 1000.50 (2007). Actual prices paid can exceed the minimum
price. Raw milk is milk that has not been processed (pasteurized).
Given these ongoing questions and the importance of the CME spot cheese
market in setting cheese and minimum milk prices in the United States, you
asked us to review the market's operations, its susceptibility to
manipulation, and the role played by various oversight and enforcement
organizations in monitoring the spot cheese market. Specifically, we
examined (1) the structure and operations of the CME spot cheese market
compared to those of NCE and ongoing concerns about price manipulation on
the CME spot cheese market, (2) how the market is regulated and efforts to
address potential price manipulation, and (3) how the CME spot cheese
market impacts federal milk pricing.
To address these objectives, we reviewed industry and academic literature
regarding market operations and obtained information from CFTC, CME, and
market participants on the structure and operations of the CME spot cheese
market. We reviewed existing studies that assessed market characteristics
associated with price manipulation, examined available trading data, and
obtained officials' views on potential manipulation. We did not attempt to
determine whether manipulation had occurred on the CME spot cheese market;
instead, we identified the characteristics of this market that were
consistent with those of markets considered susceptible to price
manipulation. We obtained and analyzed information about CFTC and other
oversight and enforcement organizations on their roles in monitoring the
CME spot cheese market. Finally, we obtained and reviewed relevant laws
and regulations related to milk pricing in the United States as well as
interviewed various agency and industry officials about the role of CME
spot cheese market prices in milk pricing. We conducted our work between
September 2006 and June 2007 in Chicago; Washington, D.C.; and two
locations in Wisconsin in accordance with generally accepted government
auditing standards.
Results in Brief
Several aspects of the structure and operations of the CME spot cheese
market are comparable to those that existed at NCE, and certain market
conditions at the CME spot cheese market continue to raise questions about
the potential for price manipulation. For example, the CME spot cheese
market, which has technical, market-specific rules based in part on NCE
rules, offers trading in some of the same products and has many of the
same industry participants as NCE. The CME spot cheese market involves
daily anonymous trading, whereas NCE traded cheese once a week and trader
identities were publicly known. Certain factors that were prevalent on NCE
and that are often associated with the potential for price manipulation
still exist, such as low trading volume and a small number of traders who
make the majority of trades. Although the CME spot cheese market averages
only a few transactions per day, CME spot cheese market prices are used by
the dairy industry in establishing the prices that are used to set
long-term contracts between market participants. While a significant
portion of the cheese industry participates in the CME spot cheese market,
the majority of trading at the CME spot cheese market is concentrated
among a small number of traders, primarily large companies and
cooperatives in the cheese and dairy industry. Therefore, certain
participants may have the ability to influence prices through transactions
on the CME spot cheese market. Factors such as daily trading may, though,
decrease opportunities for a sustained influence on prices. For example,
unlike at NCE, where a price would remain in effect for 1 week, trading on
a daily basis at CME provides more opportunities for market participants
to counter any trades that may be at prices above or below what they
consider to be market value.
The CME spot cheese market is not regulated by CFTC or USDA, but CFTC and
CME provide oversight and assess allegations of price manipulation. The
Commodity Exchange Act (CEA), which establishes the U.S. regulatory scheme
for commodity futures markets and is CFTC's enabling legislation,
prohibits manipulating the price of any commodity in interstate commerce
and provides CFTC with authority to enforce this prohibition. Moreover,
because cheese prices established on CME could impact prices in a related
futures market for milk, CFTC's Division of Market Oversight (DMO) has a
surveillance interest in the trading activity on the CME spot cheese
market. Accordingly, CFTC has examined allegations of price manipulation
in the CME spot cheese market. Moreover, mainly because of the link
between the CME spot cheese market and milk futures contracts, CFTC
surveillance staff regularly obtain data on price movements and
periodically review trends in the CME spot cheese market to identify
potential manipulative activity in related futures contracts. In addition,
CME conducts daily oversight of the market and may take disciplinary
actions to enforce its rules, which include prohibiting price manipulation
of the CME spot cheese market. CME officials noted that CME has a network
of surveillance and investigative staff observing trading, reviewing
activities of market participants, and verifying the accuracy and
completion of transactions on the spot cheese market. Both CFTC DMO and
CME officials told us that they had examined activities of participants in
the spot cheese market. These examinations may be in response to
complaints and unusual price movements identified by staff members. To
date, none of these examinations have led to an instance of CFTC taking
legal action against a market participant.
The CME spot cheese market impacts federal minimum milk prices through the
USDA National Agricultural Statistics Service (NASS) survey of cheddar
cheese prices, which is highly correlated to CME cheese prices. Prices
obtained through the NASS survey of cheese prices are a major commodity
component in USDA's minimum milk pricing formulas. The survey, as it was
intended by USDA, captured more transactions than those that occurred at
NCE, and it currently captures more transactions than occur on the CME.
USDA officials told us that the agency still uses the survey for this
reason. However, the industry, which under federal law, would need to
approve any changes to the use of the NASS survey of cheese prices in the
milk pricing formulas, has recently recommended alternative proposals
including using CME spot cheese prices instead in setting minimum milk
prices. Although USDA's Agricultural Marketing Service (AMS) is in the
process of obtaining industry input, ongoing reliance on the survey raises
three issues. First, USDA does not audit the data collected in the NASS
survey of cheese prices and therefore cannot ensure the accuracy of the
data used to calculate the minimum prices of certain types of milk.
Second, although the NASS survey of cheese prices is intended to capture
more transactions than those used in CME trading, industry participants
said they use CME cheddar cheese prices as the reference price for most of
the cheese they sell. As a result, the survey results and CME spot cheese
market prices rarely differ significantly. Third, the survey is not
particularly timely. One to 2 weeks can elapse between when some
transactions occur and when NASS survey results capturing those
transactions are released. This time lag can contribute to dairy market
participants paying minimum prices for certain milk that do not fully
reflect current market conditions.
As AMS continues to collect information and evaluate the proposals put
forth by the industry concerning the NASS cheese survey, it must balance
the interests of the industry and ensure that the information captured is
accurate. This report recommends that USDA, in conjunction with the
industry, take steps to reduce the redundancy that exists in the NASS
survey of cheese prices and improve the timeliness associated with its
survey of cheese prices. Specifically, we recommend that USDA give serious
consideration to all proposals, in consultation with the industry,
including the industry proposal to use the CME spot cheese market prices
instead of the NASS survey of cheese prices in the minimum federal milk
pricing formula. However, if USDA continues to use the NASS survey of
cheese prices, we recommend that USDA implement an auditing program for
the survey in a timely manner to ensure the accuracy of the information
provided. We provided a draft of this report to CFTC, USDA, and CME. We
received written comments from USDA, which are discussed later in this
report and reprinted in appendix II. We also received technical comments
from CFTC, USDA, and CME, which have been incorporated where appropriate.
In its response, USDA agreed with our recommendation intended to ensure
that AMS implements a program to audit data reported to NASS in its survey
of cheese prices. However, the agency disagreed with our recommendation to
proactively consider, in consultation with the industry, the industry
proposal to use CME spot cheese market prices instead of NASS survey of
cheese prices in the minimum federal milk pricing formula. Specifically,
USDA stated that it is outside of its authority to proactively consider
proposals to change federal milk marketing order provisions. USDA stated
that it would give due consideration to a current proposal to use CME spot
cheese market prices. We were not and are not recommending that USDA take
action outside of its current authority and have, therefore, clarified our
recommendation. In addition, USDA stated that the continued use of the
NASS survey seems prudent given that concerns remain about potential
manipulation at the CME spot cheese market. As we note in our report the
NASS survey of cheese prices largely duplicates prices from the CME spot
cheese market and does not address concerns about price manipulation.
Background
At any given time, participants in the cheese industry may have an
interest in buying or selling cheese for immediate delivery. Historically,
they could do so by identifying a buyer or seller through their contacts
and relationships in the industry or by participating in various
centralized markets throughout the United States where industry
participants gathered to buy and sell cheese. From 1974 to 1997, NCE was
the central market of, and functioned as a surplus market for, cheese.4 It
also served as the primary price discovery mechanism for cheese produced
in the United States.5
In general, before 1987 cheese prices on NCE experienced little
volatility, because USDA purchased cheese to ensure that cheese prices did
not fall below a certain level. After mid-1988, the volatility of cheese
prices increased sharply because of lower price supports for milk, and
NCE's role in price discovery took on additional importance until it
closed in 1997.6 While price volatility does not indicate that
manipulation is occurring, the increased volatility in cheese prices, the
corresponding effect on milk prices, and a perceived lack of oversight of
NCE raised concerns about potential price manipulation. Following a series
of investigations and congressional hearings involving NCE, a joint
committee composed of a dairy industry trade group and NCE solicited
proposals for a new site for the spot cheese market. CME was selected and
the spot cheese market began operating there in May 1997. CME, the largest
futures exchange in the United States, is a publicly traded corporation
that offers a marketplace where various commodities such as dairy products
are traded through futures contracts or spot markets. Various financial
instruments are also traded on CME.
Like NCE, the CME spot cheese market functions as a surplus market for
cheddar cheese. Industry participants consider the CME spot cheese market
a public price discovery mechanism, and prices are published daily.
Contracts for the sale of all varieties of cheese in the United States are
generally set using the prices of cheddar cheese established at CME as the
reference price. For example, a contract may specify that cheese will be
sold based on the previous week's average price of cheddar cheese set at
the CME. The contracts often include a premium or a discount on the
current price of cheddar cheese on CME based on factors such as the
quality and type of cheese and other costs such as transportation.
4The spot cheese market is commonly referred to as a surplus market. A
market with these characteristics can also be called a residual market,
which is defined as a market on which only a small proportion of the total
production or consumption of a product is actually traded on the market.
5In the process of price discovery, buyers and sellers exchange bids and
offers based on information about supply and demand for the cash commodity
and agree upon, or discover, the current price.
6Volatility is a measure of the degree to which prices fluctuate over
time.
One of the federal programs designed to assist dairy farmers is the
federal milk marketing order (FMMO) program, which is designed in part to
improve the income of dairy farmers by stabilizing market conditions and
establishing minimum milk prices.7 Under this program, USDA uses national
dairy market price information--including cheese prices--to set the
minimum prices that processors must pay for unprocessed milk in specified
marketing areas or orders. FMMOs established a four-tier classified
pricing system for setting minimum milk prices on a monthly basis, based
upon the intended use of the milk. In general, FMMO class prices are
determined by formulas that use wholesale dairy product prices. For
example, the Class III milk formula uses monthly averages of weekly
average butter, cheese, and dry whey prices to set the minimum price of
milk that is used in the production of cheeses.8 According to one industry
participant, pricing a commodity based on the prices of products that the
commodity is used to produce is unusual. Prior to using the NASS survey as
a component to calculate minimum milk prices, USDA used cheese prices from
NCE directly as an input in its milk pricing formula. As concerns were
raised from industry sources and others about manipulation of cheese
prices at NCE, USDA developed the NASS survey of cheese prices as an
alternative to using NCE prices. In 1997, USDA stopped using NCE prices in
its minimum milk pricing formulas and began using data provided by the
NASS survey of cheese prices. USDA has continued to use the NASS survey of
cheese prices in certain milk pricing formulas as trading in the spot
cheese market occurred at the CME.
77 U.S.C. S 608c, as amended.
8Dry whey is a byproduct produced from the water and solid components that
remain when cheese is manufactured.
Certain Structure and Operations of CME Spot Cheese Market Are Similar to Those
of NCE, and Certain Characteristics Result in Ongoing Concerns about the
Potential for Price Manipulation
The CME spot cheese market shares a number of operational and structural
similarities with NCE and has certain characteristics that could make the
CME spot cheese market susceptible to price manipulation. Like NCE, CME is
primarily a surplus market where small amounts of blocks and barrels of
cheddar cheese meeting certain technical specifications are traded. Many
market participants that traded at NCE also trade at the CME spot cheese
market. Moreover, certain market conditions at the CME spot cheese market,
including a small number of trades and a small number of traders who make
a majority of trades, continue to make this market particularly
susceptible to manipulation.
Some Operational Aspects of the CME Spot Cheese Market Resemble Those at NCE
NCE and CME share many similarities, including certain trading rules,
products traded, the volume of cheese traded, and market participants, but
there are differences. According to CME officials, technical rules
specific to the CME spot cheese market were developed from the rules used
to operate NCE and rules already established by CME for an existing spot
butter market. For example, CME trades the same cheese products that were
traded on NCE--carloads of 40-pound blocks and 500-pound barrels of
cheddar cheese. 9 The CME spot cheese market continues to be a surplus
market for cheese on which relatively small amounts of cheese are traded
relative to the overall size of the U.S. cheese market. Unlike some
commodities, most cheese in the United States is traded through long-term
contracts, which generally use the CME spot cheese market price as the
reference price and previously used the NCE price.
NCE had between 30 and 40 members, including major participants in the
cheese and dairy industry, such as large agricultural cooperatives, cheese
manufacturers, and processors of cheese. These members accounted for the
vast majority of cheese handled and processed in the United States.
Likewise, major cheese and dairy industry members participate on CME,
including many companies that traded cheese on NCE. CFTC officials
estimated that 13 of the 31 CME spot cheese market participants accounted
for 60 percent of all cheese produced, processed, or marketed in the
United States in 2004.10 These participants in the spot cheese market
represent diverse segments of the cheese and dairy industries, including
dairy cooperatives representing many farmers and industry participants
that produce, manufacture, and process large quantities of cheese.
9Additionally, the NCE traded 640-pound blocks. A carload of cheese is
between 40,000 and 44,000 pounds.
However, two differences exist between the CME spot cheese market and NCE.
First, the names of participants involved in NCE trading were made public.
Each member could designate up to five individuals as traders, and the
buyer and seller were reported for each trade. Trading at the CME spot
cheese market is conducted through a network of professional brokers, the
standard practice in many commodities, and the buyer and seller are not
publicly reported.11 However, according to some dairy industry
participants, they generally know which brokers represent specific buyers
and sellers. Second, trading on NCE occurred only once a week for one
30-minute session. Trading takes place at the CME spot cheese market every
weekday for at least 2 minutes and up to 16 minutes, depending on the
interest of market participants.
Thinness of the CME Spot Cheese Market, Combined with Other Factors, Contributes
to Questions about Possible Price Manipulation
Despite the move to CME, the spot cheese market remains a thin market,
which in combination with the presence of a small number of traders that
make a majority of trades and the spot cheese market's pricing structure
contributes to questions about the potential for price manipulation. A
thin market generally has either few transactions; transactions that
represent only a small proportion of the total transactions, including
those that are priced off that market; or both.12 CME and CFTC DMO
officials, some market participants, and academics generally agree that
the CME spot cheese market is a thin market. Little trading occurs on the
CME spot cheese market, and the trading that does take place consistently
represents a small proportion of the total volume of cheese produced in
the United States. According to CFTC officials, from 1998 to 2005, the
volume of cheese traded at CME generally represented less than 2 percent
of all cheddar cheese and less than 1 percent of all cheese produced in
the United States annually.13 This characteristic is not unique to the CME
spot cheese market, as other agricultural commodity markets, such as the
CME spot butter market, are also thinly traded. In addition, as shown in
table 1, on average only one or two transactions were completed during
each trading session in the barrel market, and the average was less than
one for most years, indicating that on some days no cheese was traded. The
one exception was 1997, when the average number of transactions on the
barrel market was more than eight, because the market did not have daily
trading at that time. Similarly, on average, fewer than three trades
during each trading session were completed in the block market each year.
10This study was undertaken at the initiative of CFTC surveillance staff
to review CME spot cheese market participants in 2004 and 2005. The most
recent year for which data were available is 2004.
11A commodity broker is an individual who is paid a fee for executing an
order to buy or sell a commodity for a customer.
12According to CFTC officials, not all markets in which transactions
represent a small proportion of all transactions would be considered thin.
Table 1: Average of Number of Transactions Per Trading Session by Barrel
and Block on the CME Spot Cheese Market, 1997-2006
Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Total
Average barrel 8.2 1.8 1.4 2.2 0.8 0.8 0.4 0.9 0.7 0.7 1.2
Total barrel 296 216 358 566 189 191 98 229 184 170 2,497
Average block 4.4 3.3 3.5 2.3 1.9 2.5 2.2 2.9 2.6 1.4 2.5
Total block 157 383 873 599 479 626 536 728 657 348 5,386
Source: GAO analysis of CME data.
Academic analyses and cheese and dairy industry participants have raised a
number of concerns associated with thin markets being susceptible to
manipulation. These concerns include the following:
o Dominant traders may be able to attempt to manipulate prices
more easily in thin markets.
o Prices in thin markets may not reflect supply and demand, even
without manipulative behavior by dominant traders.
As noted, thin markets raise concerns about the potential for
manipulation because of the small number of participants and
transactions involved in the market and the ease with which prices
can be impacted. For example, in thinly traded markets each
individual participant's activity tends to be more influential
than it would be on a market with more transactions and more
participants. As a result, it may be easier for a market
participant to move prices in a preferred direction over a short
period of time with relatively few completed or unfilled
transactions. Further, individual transactions to buy and sell
cheese that set the market price may not accurately reflect supply
and demand.
Further, the CME spot cheese market has a small number of traders
who make the majority of trades, another factor that contributes
to questions about possible price manipulation. Relatively few
market participants account for the majority of trading at the CME
spot cheese market, as shown in figure 1. Between January 1, 1999,
and February 2, 2007, two market participants purchased 74 percent
of all block cheese, and three market participants sold 67 percent
of all block cheese. During the same time period, four market
participants purchased 56 percent of all barrel cheese, and two
market participants sold 68 percent of all barrel cheese.
13In 1999 trading represented slightly more--less than 2.5 percent of all
cheddar produced in the United States.
Figure 1: Percentage of Trading, by Largest Block and Barrel Market
Participants, January 1, 1999, to February 2, 2007
In addition, the CME spot cheese market's pricing structure, in
combination with a thinly traded market and a small number of traders who
comprise the majority of trading, contributes to questions about the
potential for price manipulation. As on many other financial markets,
prices at the CME spot cheese market are based on completed transactions
and on unfilled higher bids and uncovered lower offers that are posted by
market participants.14 During a trading session an unfilled bid that is
higher than the previous bid or transaction price can result in a higher
price. Similarly, an uncovered offer that is lower than the previous offer
or transaction price can result in a lower price. For example, on the CME
spot cheese market:
o Between January 1, 1999, and February 2, 2007, the closing price
for block cheese fluctuated based on unfilled bids and uncovered
offers on at least 17 percent of the trading days.15 During the
same time period, the barrel market closing price fluctuated based
on unfilled bids and uncovered offers 28 percent of trading days.
o Between March 1, 2004, and April 16, 2004, block cheese prices
increased from $1.49 to $2.20 per pound, or 48 percent, on the CME
spot cheese market based primarily on unfilled bids to buy cheese,
with only four carloads of block cheese bought or sold during this
period.
o Between October 26, 2004, and November 19, 2004, block cheese
prices rose from $1.57 to $1.80 per pound, or 14 percent, with
completed transactions for only three carloads of cheese completed
during this period.
This pricing structure is not unique to the CME spot cheese
market, and price changes based on unfilled bids and uncovered
offers may reflect conditions consistent with supply and demand.
However, this pricing structure may increase opportunities to
ultimately change the price of milk without reference to the
actual costs of buying and selling cheese.
Finally, although there may be characteristics that raise concerns
about price manipulation, certain characteristics of the CME cash
cheese market may reduce the risk of price manipulation. According
to CME officials and industry participants, the risk of incurring
the expenses associated with the actual buying or selling of
cheese may deter some market participants from attempting to
manipulate prices at the CME spot cheese market. Any CME spot
cheese market participant who makes a bid or offer risks
acceptance of that bid or offer and the obligation to buy and
accept delivery of cheese or to sell and make delivery. Completed
transactions for the purchase or sale of cheese can involve a
significant expense. While a relatively small number of traders
make the majority of trades q, market participants represent a
significant amount of potential volume of trading. CFTC has found
that many large participants in the cheese and dairy industry with
diverse interests monitor the CME spot cheese market and are
prepared to participate in it. These large industry participants
could, for example, buy cheese on the CME spot cheese market if
prices fell below a company's manufacturing costs or sell it if
prices rose to a profitable level, potentially countering any
attempted manipulation. Several industry participants we
interviewed said that they believed that price manipulation on
this market would be difficult to sustain, given the number of
competing interests. Additionally, the change from once-a-week
trading on the NCE market to daily trading on the CME spot cheese
market may make sustaining attempted price manipulation more
difficult because a trader may have to be active in the market on
a daily basis in order to influence prices. Despite allegations of
price manipulation, industry participants we interviewed stated
that they generally did not believe manipulation was occurring. In
addition, industry participants told us that they never stopped
using the CME price as a reference price in their long-term
contacts.
14A completed transaction on the CME spot cheese market is an agreement
between a buyer and a seller for the purchase of a specific quantity of
cheese at a given price. An unfilled bid is an indication of willingness
to buy a specific quantity of cheese at a given price that remains open
and is not accepted by a seller. An uncovered offer is an indication of
willingness to sell a specific quantity of cheese at a given price that
remains open and is not accepted by a buyer.
15Additionally, there may have been days in which there were completed
transactions, but the closing price was based on an unfilled bid or
uncovered offer.
CFTC and CME Provide Increased Oversight of the CME Spot Cheese Market
Both CFTC and CME engage in activities that may detect or deter
potential price manipulation at the CME spot cheese market.16
Regular monitoring by CFTC DMO and CME represents a significant
change from the level of oversight of NCE, which had received
limited monitoring from CFTC and NCE staff. CFTC, as part of its
responsibility for the regulation of commodity futures markets,
monitors cash markets that affect futures markets, such as the CME
spot cheese market. CFTC surveillance staff review trading
activities on the market for manipulative activity, including
manipulation that may impact the Class III milk futures. Moreover,
CFTC Division of Enforcement can act on indications of
manipulative activity through CFTC's authority to enforce the CEA,
which specifically prohibits the manipulation of prices of
physical commodities in interstate commerce.17 CME conducts daily
surveillance of the CME spot cheese market based on its
established rules and internal procedures. Both CFTC enforcement
staff and CME investigate and, if appropriate, can take
enforcement actions in response to potential manipulative conduct
on the CME spot cheese market. However, proving price manipulation
is difficult.
16CFTC DMO has regulatory responsibility, among other things, to provide
market surveillance for futures markets. As a part of this responsibility,
CFTC DMO monitors markets to identify situations that could pose a threat
of manipulation and initiate preventative actions.
CFTC Monitors Trading Activity to Identify and Address Potential
Price Manipulation on the CME Spot Cheese Market
In recent years, CFTC DMO staff have monitored the CME spot cheese
market on a regular basis both to review that prices of related
Class III milk futures contracts are consistent with forces of
supply and demand and in response to complaints alleging
manipulative conduct. CFTC DMO is particularly concerned about
manipulative activities in cash markets when prices on those
markets could affect the integrity of futures contract prices. The
price paid for a Class III milk futures contract is based on the
monthly Class III milk price released by USDA, which is heavily
influenced by the price of cheese at the CME spot cheese market.
Also, because the CEA prohibits manipulating the price of any
commodity in interstate commerce, CFTC can take action under its
enforcement authority to investigate price manipulation of any
commodity, regardless of whether it is related to a futures
contract. According to CFTC DMO officials, however, CFTC
surveillance staff would be unlikely to monitor commercial
activities involving a commodity without a related futures market.
CFTC surveillance staff regularly obtain and analyze data on the
activities of the CME spot cheese market participants to assist in
the detection and also prevention of price manipulation in related
futures markets. In 2005, CME began providing CFTC with daily
trading data and information on the CME spot cheese market on a
monthly basis.18 CFTC monitors traders with large positions in
Class III milk futures and the trades that these large traders
make in the CME spot cheese market. As part of its monitoring,
CFTC focuses on answering the following questions:
1. Is the Class III milk futures price consistent
with supply and demand factors in the cheese
industry?
2. How is the monthly Class III milk price released
by USDA behaving compared to the CME spot cheese
market and other cash prices?
3. Are the largest Class III milk futures traders
engaged in trades on the CME spot cheese market that
affect the monthly Class III milk price released by
USDA?
4. Do the Class III milk futures traders have an
incentive to engage in losing trades on the CME spot
cheese market in order to benefit a large futures
position?
17CFTC Division of Enforcement investigates and prosecutes alleged
violations of the CEA and CFTC regulations. The prohibition against price
manipulation in interstate commerce is set forth at 7 U.S.C. S 13b.
18Prior to 2005, CFTC made individual requests to CME for data on the CME
spot cheese market.
In its market surveillance activities, CFTC surveillance staff may
use many sources of daily market information. Some of this
information is publicly available, including data on the overall
supply, demand, and marketing of the underlying commodity;
futures, option, and cash prices; and data on trading volume and
open contracts.19 Some of the information is highly confidential,
including data from exchanges, intermediaries, and large traders.
CFTC Chicago surveillance staff generally review CME spot cheese
market transactional data from CME, which include the identities
of buyers and sellers and timing of trades, when they see unusual
price movements and to summarize the data for informational
purposes. CFTC surveillance staff may also interview industry
participants, and interviews may include discussions about basic
market fundamentals, the traders' involvement in specific
commercial transactions, or the traders' observations about
anything unusual about the CME spot cheese market or other cash
transactions.
CFTC DMO staff have prepared summary documents analyzing the
market four times since 1999, including analyses of participants,
volume, and price fluctuations. Generally, they have found that
the majority of the cheese industry is represented at the CME spot
cheese market and that trading on the market is concentrated among
a small number of participants. CFTC has filed no complaints
related to price manipulation on this market. These reviews
represent another change from NCE, which, according to CFTC
officials, CFTC did not monitor regularly. CFTC did review trading
activities on NCE in 1997 prior to approving a market for trading
in certain milk futures. This review did not identify significant
deficiencies or suggest that the market was susceptible to
manipulation. In contrast, after a 4-year investigation in which
confidential and proprietary information was gathered, University
of Wisconsin economists found that the organization of NCE
appeared to facilitate market manipulation, but could not
definitively conclude that manipulation had occurred, and that NCE
was not an efficient price discovery mechanism between 1988 and
1993.20 Market participants told us that CFTC monitoring of the
CME spot cheese market addressed some of their concerns about
limited oversight of trading at NCE.
19An option is a contract that gives the buyer the right, but not the
obligation, to buy or sell a specified quantity of a commodity or other
instrument at a specific price within a specified period of time,
regardless of the market price of that instrument. Open contracts are the
total number of futures contracts long or short in a delivery month or
market that has been entered into and not yet liquidated by an offsetting
transaction or fulfilled by delivery. A short position on a futures
contract is taken by a trader who agrees to sell a commodity at some point
in the future. A long position on a futures contract is taken by a trader
who agrees to purchase a commodity at some point in the future.
In addition to identifying unusual activities or manipulative
conduct through its monitoring activities, CFTC also responds to
complaints and concerns raised by industry members and the public.
CFTC surveillance staff in Chicago collaborate with CME officials
to examine trading activities. Since 1999, CFTC Chicago DMO staff
have done nine special reviews of trading activity at the CME spot
cheese market in response to specific complaints or fluctuations
in market prices. These complaints dealt with issues including an
allegation that a market participant failed to pay in a timely
manner for cheese purchased on the CME spot cheese market,
allegations of price manipulation on that market, and concerns
about price volatility on that market. According to CFTC
officials, the CFTC market surveillance analyst responsible for
the Class III milk futures market reviewed these complaints,
analyzed the time period or market participants involved in the
allegation, and responded to the party that complained. None of
these reviews resulted in any legal action taken by CFTC against a
market participant. According to trade press reports, CFTC is
currently investigating the trading activity of one participant in
the CME spot cheese market for potential manipulation of the
market. Unless otherwise authorized, CFTC regulations require
enforcement investigations to be nonpublic. Therefore, CFTC does
not confirm, deny, or comment about possible ongoing
investigations.
20Bruce Marion, Willard Mueller, et. al. "Cheese Pricing: A Study of the
National Cheese Exchange," University of Wisconsin (March 1996).
According to CFTC DMO officials, CFTC generally would not take an
active role in oversight of the CME spot cheese market without a
related futures market because of its interpretation of its
responsibilities under CEA and limited resources. However, other
federal agencies have responsibilities relating to the
manipulation of cash cheese prices even in the absence of a
related futures contract. The U.S. Department of Justice (DOJ) has
responsibility for investigating possible violations of the
antitrust laws and taking appropriate legal action in the courts.
DOJ's authority includes taking action based on unreasonable
restraints of trade such as price fixing or manipulation. In
addition, the Federal Trade Commission (FTC) is charged by statute
with preventing unfair methods of competition and unfair or
deceptive acts or practices in or affecting commerce. In order to
avoid duplicating efforts to pursue allegations of anticompetitive
behavior or price fixing, the two agencies developed and
maintained a liaison arrangement to determine who would take the
lead on any cases involving the CME spot cheese market.
Certain other federal and state agencies that observed or
monitored trading at NCE no longer do so at the CME spot cheese
market. In the past, USDA officials observed trading and published
prices established at NCE but do not observe CME spot cheese
market trading. Prices are now publicly reported. USDA officials
did not provide oversight of NCE and have no oversight role of
CME. NCE was also subject to the Wisconsin Department of
Agriculture, Trade and Consumer Protection's jurisdiction over
unfair competition and trade practices. According to CME
officials, no state agency has a role in overseeing CME or the CME
spot cheese market.
In addition to monitoring trading in the futures markets and
related cash markets, CFTC has general authority, provided by the
CEA, over designated contract markets.21 CME, as a designated
contract market, must demonstrate to CFTC that it meets CEA
criteria for the prevention of market manipulation, fair and
equitable trading, the conduct of trading facilities, and the
financial integrity of transactions. In addition to providing
market surveillance, CFTC DMO approves and oversees the futures
exchanges, including CME, and reviews exchange rules.22 CFTC also
assesses the effectiveness of compliance and market surveillance
capabilities and reviews new futures contracts to assess their
susceptibility to manipulation. To ensure the market's financial
integrity, CFTC Division of Clearing and Intermediary Oversight
reviews the audit and financial surveillance activities of
self-regulatory organizations (SRO), including CME.23 According to
CFTC officials, they have not approved CME spot cheese market
rules. However, CFTC conducted a rule enforcement review of CME
that covered the time period October 2004 to October 2005.24 This
review, which did not specifically include the CME spot cheese
market rules, included an examination of the compliance of a
number of CME's programs with CEA, including the audit trail,
trade practice surveillance, disciplinary, and dispute resolution
programs. CFTC did not make any recommendations for improvements
in these areas.
21A designated contract market is a market designated by CFTC to trade
futures and options under the CEA. See 7 U.S.C. S 7.
22See 7 U.S.C. S 7(b).
Proving actual or attempted price manipulation is difficult,
according to CFTC officials.25 They noted that CEA does not have a
specific definition of manipulation. Rather, it has been left to
the courts to develop the law through cases or decisions.
Accordingly, as established by federal courts and CFTC, proving
manipulation requires being able to show the following:
o The market participant had the ability to influence market
prices.
o The market participant specifically intended to influence
prices.
o Artificial prices existed.
o The market participant caused an artificial price.26
Proof of an attempted manipulation requires sufficient evidence of
(1) an intent to affect the market price and (2) some overt act in
furtherance of that intent.27 Like the test for manipulation, the
test for attempted manipulation depends upon the facts and
circumstances of a particular market and its participants.28 We
did not find any studies or court cases that have concluded that
there has been manipulation on the CME spot cheese market or NCE.
23Self regulatory organizations include exchanges and registered futures
associations that enforce financial and sales practice requirements for
their members.
24A rule enforcement review is an analysis of an exchange's overall
compliance capabilities.
25The prohibition against manipulation of prices of commodity futures and
commodities in interstate commerce is set forth in the CEA at 7 U.S.C. S
13b.
26In re Cox, [1986-1987 Transfer Binder] Comm. Fut. L. Rep. (CCH) 23,786
at 34,061 (CFTC July 15, 1987); see also Frey v. CFTC, 931 F.2d 1171 (7th
Cir. 1991); CFTC v. Enron Corp., 2004 U.S. Dist. Lexis 28794 (S.D. Tex
2004).
An intent to raise or lower CME spot cheese market prices could be
based on a variety of incentives. For example, farmers that
produce milk used to manufacture cheese benefit when the price of
cheese on the CME spot cheese market is high because the CME spot
cheese market influences a broad array of cheddar cheese prices
that are included in the pricing formula for Class III milk.
Alternatively, a company that largely sells cheese purchased from
others could benefit from low CME spot cheese market prices. This
is because most cheese plants from which it buys would be using
the lower CME cheese prices to set their contract price, but it
would sell its cheese at a price not based on CME prices. These
factors alone do not imply that price manipulation has
occurred--in fact, price manipulation has not been proven--but
these incentives appear to contribute to ongoing questions about
the susceptibility of the market to manipulation relative to one
with more trading or more market participants comprising the
majority of trades.
Further, identifying actual or attempted manipulation on the CME
spot cheese market can be difficult for a number of other reasons.
First, because the CME spot cheese market functions as a market to
dispose of excess supply or to fill temporary inventory needs, it
may not always reflect prices that are consistent with supply and
demand in the broader market as market participants attempt to
manage short-term inventory needs through the CME spot cheese
market. For this reason, determining what constitutes an
artificial price can be difficult. In addition, companies may
attempt to influence prices without considering their activity to
be manipulative. For example, according to one industry
participant, traders may act to influence the spread between the
prices of barrel cheese and block cheese to keep it in line with
general historical trends. Finally, USDA officials and industry
participants told us that some market participants used the CME
spot cheese market as a forum to "register an opinion" on what
they believed cheese prices should be by making bids and offers
with the intent to change the price of cheese to more closely
align with their opinions of supply and demand conditions.
Representatives of two market participants we interviewed said
that they did not believe that this activity constituted
manipulation on the CME spot cheese market. However, CFTC
enforcement officials disagreed and believe that the types of
behavior described above may constitute manipulative behavior.
27See In re Abrams, [1994-1996 Transfer Binder] Comm. Fut. L. Rep. (CCH) P
26,479 at 43,136 (CFTC) July 31, 1995). See also In re Hohenberg Brothers,
[1975-1977 Transfer Binder] Comm Fut. L. Rep. (CCH) P 20,271 at 21,477
(CFTC Feb. 18, 1977).
28See Cargill v. Hardin, 452 F.2d 1154, 1163 (8th Cir. 1971), cert.
denied, 406 U.S. 932 (1972) (Manipulation cases tend to be characterized
by fact-specific, case-by-case analysis, which examines whether prices
have been affected by factors other than the legitimate forces of supply
and demand.); see also Frey v. CFTC, 931 F.2d 1171, 1175 (7th Cir. 1991).
Accord In re Indiana Farm Bureau Cooperative Association, [1982-1984
Transfer Binder] Comm. Fut. L. Rep. (CCH) P 21,796 at 27,281 (CFTC Dec.
17, 1982) (defining manipulation or attempted manipulation "has fallen to
case-by-case judicial development")
CME Conducts Daily Surveillance of the CME Spot Cheese Market
CME rules govern its oversight of the CME spot cheese market. CME,
as an SRO, is responsible for establishing and enforcing rules
governing member conduct and trading; providing for the prevention
of market manipulation, including monitoring trading activity;
ensuring that futures industry professionals meet qualifications;
and examining exchange members for financial strength and other
regulatory purposes. CME rules authorize the managing director of
regulatory affairs to enforce CME rules and gather all the
information necessary to investigate abuses of trading practices.
Through this authority, CME monitors trading activities, collects
data on its markets, and inspects the books and records of
members. In addition, the managing director of regulatory affairs
may investigate and recommend institution of disciplinary
proceedings for alleged violations of CME rules.
CME conducts surveillance and investigations of the CME spot
cheese market through its market regulation division. CME's market
regulation division employs market surveillance analysts, one of
whom is assigned to monitor the CME spot cheese market, among
others. According to CME officials, the market surveillance
analyst assigned to the CME spot cheese market monitors daily
trading, maintains familiarity with traders and industry news and
trends, and reviews large price changes resulting from uncovered
bids or offers and determines the identity of market participants.
The analyst reviews and analyzes spot call cheese trade activity
in relation to Class III milk futures positions. The analyst,
along with market regulation staff, handles inquiries and
complaints from market participants and firms, contributes to
contract specification changes and rule language updates, and
regularly participates in problematic delivery-related issues. The
analyst physically observes trading at the CME spot cheese market
on average three times a week. In addition, the analyst reviews
the input of daily trading data into a CME database to ensure that
trades are properly recorded and that clearing member firms verify
their assigned transactions and provide buyer and seller
identification and relevant delivery details.29
In addition to employing market surveillance staff, CME assigns
one investigator to regularly review the CME spot cheese market to
identify potential violations of trading practices and determine
if trader activity is adversely affecting Class III milk futures.
According to CME officials, they have investigated trading
activity related to delivery of cheese sold on the CME spot cheese
market and have disciplined two traders. However, CME officials
told us that CME has only rarely opened formal investigations into
traders on the spot cheese market for rules violations. This
surveillance is stricter than at NCE, which had rules against
manipulating prices but no staff to oversee the market and
generally did not investigate trading activities.
According to CME officials, CME market regulation staff also
review traders' positions and activities in the CME spot cheese
and Class III milk futures markets to determine if a trader's
futures positions would benefit from price changes on the spot
cheese market. For example, the market surveillance analyst may
look for trading activity on the CME spot cheese market that might
directly benefit a trader's futures positions, such as selling
cheese in order to lower prices and benefit a short position in
Class III milk futures. The market surveillance analyst for the
CME spot cheese market also reviews trading data from both markets
for large price changes and market trends.
Finally, CME annually provides a dairy forum for CME spot cheese
market participants to meet and discuss potential improvements to
the spot cheese market. Forum meetings have included discussion of
such topics as electronic trading, anonymous trading, daily limits
on trading, and technical specifications for products traded.
Working committees have been formed based on these meetings, and
CME staff told us that they would focus on potential improvements
that received majority support as expressed at the forum.
According to market participants, regular monitoring and oversight
of the CME spot cheese market by CME officials has addressed
certain industry concerns about potential price manipulation that
existed when NCE operated the spot cheese market.
29Clearing member firms are entities through which futures and other
transactions are cleared and settled. They are also charged with ensuring
the proper conduct of each contract's delivery procedures and the adequate
financing of trading.
The USDA Survey of Cheddar Cheese Prices Largely Duplicates CME
Cheese Prices and Introduces a Time Lag into Some Milk Prices
The NASS survey of cheese prices, which is a major determinant of
some FMMO minimum milk prices, is not currently audited by USDA,
largely duplicates reported CME cheese market prices, and
introduces a 1- to 2-week time lag between when data are reported
by NASS and when transactions captured in the survey occur.30 USDA
used to rely on the price of 40-pound blocks of cheddar determined
on NCE in pricing milk, but developed the NASS survey of cheese
prices in response to concerns, raised by industry and others,
about a thin market and the potential for price manipulation on
NCE. As stated by the Secretary of Agriculture at a hearing before
a subcommittee of the U.S. Senate Committee on Appropriations in
March 1997, USDA began conducting a national survey of cheddar
cheese prices in response to concerns about the accuracy of
reported prices at NCE. The NASS survey of cheese prices is
intended to capture more transactions than those occurring on the
CME spot cheese market. According to USDA officials, the NASS
survey of cheese prices has continued to be used in the milk
pricing formula. However, USDA's ongoing reliance on the survey
raises three issues. First, USDA does not audit the data reported
in the NASS survey of cheese prices to ensure the accuracy of the
prices reported. Second, industry participants use the CME spot
cheese market price as a reference price, and survey results and
CME spot cheese market prices rarely differ significantly. Third,
the timing of the survey introduces into certain milk prices a 1-
to 2-week time lag between when data are reported by NASS and when
transactions captured in the survey occur. Figure 2 provides an
overview of how CME spot cheese prices influence milk pricing.
30According to analyses by the University of Wisconsin, from January 2000
to January 2007, cheese prices have determined upward of 83 percent of the
USDA price of Class III milk.
Figure 2: Influence of CME Spot Cheese Market Prices on Class III Milk
Pricing
USDA began using NASS survey cheese data as an input into milk pricing
formulas after NCE closed. Since USDA began using data from the NASS
survey of cheese prices in its milk pricing formula, the agency has held
hearings in response to industry concerns about the pricing formulas for
Class III milk. Some industry participants have put forth a number of
proposals related to eliminating the use of the NASS survey of cheese
prices in milk pricing, including proposals in 2000 and 2006, that
recommended eliminating the use of the NASS survey and instead using CME
spot cheese market prices in the milk pricing formulas.31 In 2000, in
hearings on milk order reform, industry opinions varied on the use of CME
cheese prices instead of the NASS survey of cheese prices, with some
industry participants stating that they preferred the use of the NASS
survey of cheese prices. USDA decided to continue to use the NASS survey
of cheese prices, stating that the NASS survey prices are based on a much
greater volume than using CME prices. As of June 2007, hearings were still
being held regarding the more recently submitted proposal, which
recommended using CME prices instead of NASS survey prices. A final
regulation would be subject to industry approval requirements contained in
the statute.32 USDA officials have told us that historically there has
been a lack of consensus in the industry to make this change. Several milk
producers and cheese manufacturers we interviewed stated that they
generally supported the idea of no longer using NASS survey prices in the
milk pricing formulas. In order to assess the potential impact of current
proposed changes to the Class III milk pricing formulas, the USDA
conducted preliminary economic analyses, which analyzed the change to
historical Class III milk prices if CME spot cheese market prices had been
used instead of the results of the NASS survey of cheese prices.33 On the
basis of this analysis, USDA concluded that using the CME spot cheese
market prices instead of the NASS survey of cheese prices would lead to a
difference of little significance.
31CME spot cheese market prices could be used in federal minimum milk
pricing provided that the CME spot cheese market remains open for trading.
Under the milk marketing orders, NASS collects dairy market prices, such
as the NASS survey of cheese prices, for use in USDA's milk pricing
formulas, which raises three issues.34 First, USDA does not currently
audit responses provided by survey participants. Under the Dairy Market
Enhancement Act of 2000, mandatory price reporting requirements for dairy
products used in setting milk prices were established.35 Additionally,
USDA was authorized to conduct audits of transactions reported by survey
participants.36 Auditing the transactions could help to ensure the
accuracy of the information used to establish minimum milk prices under
the FMMOs. However, USDA does not currently audit these transactions,
which include transactions captured in the NASS survey of cheese prices.
Agency officials told us that they had developed a proposed rule to
conduct audits of the data. According to a USDA official, the proposed
rule is currently under review by the Office of Management and Budget.
Recently, USDA disclosed that there had been a reporting error in the data
included in its survey of nonfat dry milk prices. According to USDA
officials, this error affected milk prices for farmers for at least 2
months and caused a market loss of at least $6.4 million. Without auditing
the data provided in the NASS survey of cheese prices, USDA cannot ensure
the accuracy of the data that are used in the milk pricing formulas.
32See the Agricultural Marketing Agreement Act of 1937, as amended, 7
U.S.C. S 608c (8), (18).
33USDA, Preliminary Economic Analysis Class III and Class IV Prices,
Agricultural Marketing Service, February 2007. In this economic analysis,
USDA uses an econometric model in which it substituted NASS survey of
cheese prices for CME spot cheese market prices and projected the
potential effect on milk prices.
34In a 2004 report, GAO provided information on various dairy policy
options. GAO, Dairy Industry: Information on Milk Prices, Factors
Affecting Prices, and Dairy Policy Options, [19]GAO-05-50 (Washington,
D.C.: Dec. 29, 2004).
35Pub. L. No. 106-32 (Nov. 22, 2000).
36See 7 U.S.C. S 1637b(c)(3), as amended by Pub. L. No. 106-32 S 2.
Second, although USDA officials told us that the NASS survey captured a
wider range of cheese prices than using prices from the CME spot cheese
market, the survey captures the weekly average CME spot cheese market
price because cheese manufacturers use the CME spot cheese market price as
a reference price plus or minus a premium or discount depending upon the
specifications of the cheese. As a result, price manipulation on the CME
spot cheese market, if reflected in the NASS survey, could lead to certain
federal order minimum milk prices being artificially high or low. Despite
surveying a broader range of transactions, the survey provides limited
additional information beyond what is already available directly from the
CME spot cheese market and results in a high correlation between the NASS
survey of cheese prices and CME spot cheese market prices (see fig. 3).
According to a University of Wisconsin study, the NASS survey has a 98
percent correlation with CME spot cheese market prices when adjusted to
account for the difference in timing between collecting price information
and publishing survey results.37 USDA has generally not analyzed
differences between the NASS survey prices and CME spot cheese market
prices such as those in figure 3. Additionally, while industry
participants recognize the role of the NASS survey of cheese prices in
setting certain minimum federal order milk prices, industry participants
we interviewed said the survey did not provide them with useful
information. Industry participants told us that small differences between
the two price series are likely due to premiums and discounts negotiated
into contract prices, such as for transportation costs.
37Ed Jesse, "Backcasting Formula-Based Federal Order Class Prices,"
University of Wisconsin (October 2004).
Figure 3: CME Spot Cheese Market and NASS Cheese Survey Block Cheese
Prices
The third issue raised by USDA's use of the NASS survey of cheese prices
is that the results are not released for 1 to 2 weeks after certain
transactions captured in the survey occur. California Department of Food
and Agriculture officials told us that California does not participate in
FMMOs. They also told us that California does not rely on the NASS survey,
in part because of concerns about the timing of the survey. Additionally,
although industry members we interviewed stated that the effects of the
time lag may balance out over time, they said that the use of the NASS
survey created short-term problems in milk pricing because of the time
lag. For example, one industry member said that because of a timing lag
that can occur during periods of rapidly declining cheese prices at the
CME spot cheese market, USDA minimum milk prices may not fully reflect
current milk prices. As a result, cheese manufacturers may be buying milk
based on prices calculated using higher cheese prices from the preceding
weeks but selling cheese at current lower market prices. This is due in
part to the time lag in the NASS survey of cheese prices and could cause,
in the short term, losses for the manufacturer. However, dairy farmers may
benefit in this example. In periods of rapidly rising cheese prices, the
time lag could result in dairy producers receiving less for their milk
than if current market conditions were reflected in the minimum milk
prices. In this example, cheese manufacturers might benefit.
According to USDA officials, the effect of the time lag inherent in the
NASS survey of cheese prices on Class III milk prices is diminished by two
factors. First, USDA publishes the minimum Class III milk price on a
monthly basis, and according to USDA officials, this dilutes the effect of
the time lag on the Class III minimum milk price. Second, according to
USDA, 75 percent of milk is sold with a premium over the Class III minimum
milk price, and these "over-order" premiums reduce the effect of the time
lag in the Class III minimum milk price.38 However, monthly Class III
minimum milk prices can sometimes be based on data that do not include a
portion of or the entire last week of NASS survey of cheese data for that
month. This can be compounded because industry participants sometimes base
their cheese prices on the prior week's CME spot cheese market price. As a
result, the effect of the time lag would be present in the monthly Class
III milk price. Moreover, according to some industry participants we
interviewed, the Class III minimum milk price is used by industry
participants as the base price onto which over-order premiums are applied.
This means that if the minimum milk price is too high or too low because
of the effect of the lag, the lag would be reflected in milk prices set by
industry participants who start with the minimum price and add a premium.
Therefore, the time lag may result in industry members paying or receiving
prices for milk that no longer fully represent current market conditions.
Conclusions
The move from NCE to CME changed little about the structure or function of
the spot cheese market but has increased oversight. The CME spot cheese
market continues to be a surplus market where a few large participants buy
and sell cheese and less than 1 percent of the cheese produced in the
United States is traded. In addition, market participants continue to use
CME spot cheese market prices to set most cheese prices in the United
States. As a result, concerns about price manipulation will likely remain.
However, monitoring of trading activity by CFTC DMO and CME represents a
substantial increase in the level of oversight of the CME spot cheese
market as compared to oversight of NCE. This has addressed some concerns
about potential price manipulation on the CME spot cheese market. While
not guaranteeing that price manipulation will be detected or prevented,
regular and targeted reviews may help to ensure the integrity of and
confidence in the market.
38Over-order premiums refer to charges that are negotiated by milk sellers
(individual farmers and cooperatives) and milk buyers (fluid milk
processors and dairy product manufacturers such as cheese makers) that are
above the minimum milk price.
The CME spot cheese market also impacts minimum milk prices through the
NASS survey of cheese prices, which largely captures the CME spot cheese
price but with a 1- to 2-week lag. USDA developed the NASS survey of
cheese prices, in part to address industry and other concerns about a thin
market and potential price manipulation. However, despite surveying a
broader range of transactions, the industry uses the CME spot cheese
market as the primary mechanism for price discovery and for pricing the
majority of cheese sold. As a result, the NASS survey continues to capture
largely redundant spot cheese market prices. Any small difference between
prices from the NASS survey and CME spot cheese prices may be due to
factors such as a time lag between data collection and price reporting,
premiums or discounts on the CME price, or errors in data collected in the
NASS survey of cheese prices. In addition, the NASS survey data are not
currently audited by USDA, and a recent error in nonfat dry milk prices
has raised questions about the accuracy of the data reported. California,
with one of the largest dairy industries in the country, has chosen to use
CME cheese prices over NASS survey of cheese prices in its milk pricing
formula because officials believe they more accurately reflect current
market conditions. The NASS survey of cheese prices largely captures CME
price data by surveying producers versus capturing current data directly
from CME. A lag of 1 to 2 weeks exists in data collected in this survey.
As a result, industry participants may be paying prices for milk that may
not be current.
Recommendations for Executive Action
As USDA continues to hold hearings on a variety of issues, including the
Class III milk pricing formula, we acknowledge that there may be a variety
of proposals to consider. To improve the timeliness of reported cheese
prices and reduce redundancy that exists in the NASS survey of cheddar
cheese, we recommend that the Secretary of USDA direct the Administrator,
Agricultural Marketing Service to give serious consideration to all
proposals, in consultation with the industry, including the industry
proposal to use the CME spot cheese market prices instead of the NASS
survey of cheese prices in the minimum federal milk pricing formula.
If USDA continues to use the NASS survey of cheese prices, we recommend
that the Secretary of USDA direct the Administrator, AMS, to implement in
a timely manner a program to audit data reported to NASS in its survey of
cheese prices.
Agency Comments and Our Evaluation
We provided a draft of this report to CFTC, USDA, and CME. We received
written comments from USDA, which are reprinted in appendix II. We also
received technical comments from CFTC, USDA, and CME, which have been
incorporated where appropriate. In written comments from the Under
Secretary of Marketing and Regulatory Programs, USDA agreed with our
recommendation intended to ensure that AMS implements a program to audit
data reported to NASS in its survey of cheese prices. However, the agency
disagreed with our recommendation to proactively consider, in consultation
with the industry, the industry proposal to use CME spot cheese market
prices instead of NASS survey of cheese prices in the minimum federal milk
pricing formula.
In response, USDA noted, as we do in the report, that it is in the process
of holding a hearing addressing proposed changes to the federal milk
marketing order minimum price formulas and that using the CME spot cheese
price is among the proposals. According to USDA, it is outside of USDA's
authority to "proactively consider" proposals to change federal milk
marketing order provisions. We have, therefore, clarified our
recommendation. We were not and are not recommending that USDA take action
outside of its current authority and we recognize that USDA must follow
its rules of practice and procedure when conducting proceedings to amend
marketing orders. Specifically, USDA states that proposals to use the CME
price will be given "due consideration, weighing both the supporting and
opposing testimony" in the hearing process. Our recommendation is that
USDA give serious consideration to all proposals, in consultation with the
industry, including the industry proposal to use the CME spot cheese
market prices instead of the NASS survey of cheese prices in the minimum
federal milk pricing formula.
USDA also stated that because concerns remain about potential manipulation
at the CME spot cheese market, "use of the NASS price to set FMMO minimum
prices seems prudent until an alternative is shown to be clearly
superior." While we recognize that there are potentially a variety of ways
to price Class III milk, the use of CME spot cheese market prices has
certain merits over using NASS prices. As stated in our report, while
concerns remain about price manipulation at the CME spot cheese market,
the NASS survey of cheese prices does not address these concerns. The NASS
survey of cheese prices largely duplicates CME spot cheese market prices.
Use of CME spot cheese market prices instead of NASS survey of cheese
prices could reduce redundancy. As USDA itself has found, the long-term
difference in using CME spot cheese prices instead of NASS survey of
cheese prices in milk pricing is close to zero. This is because, as we
note in our report, the cheese industry uses CME spot cheese prices to set
contract prices. As a result, CME spot cheese market prices are captured
by the NASS survey of cheese prices. Further, industry participants that
we interviewed stated that they have not adjusted how they set contract
prices due to concerns about manipulation on the CME spot cheese market.
Therefore, any pricing concerns about CME would also be reflected in the
NASS survey prices.
USDA further stated that GAO has not demonstrated that there has been a
loss or benefit to cheese makers due to the time lag associated with
calculating a monthly average federal minimum milk price. However, the
report does include an example of a potential loss to cheese makers. As
stated in the report, one industry member we interviewed told us that
during periods of rapidly declining cheese prices at the CME spot cheese
market, the timing lag may result in USDA minimum milk prices not fully
reflecting current milk prices and may result in cheese makers buying milk
at prices higher than the prices at which the cheese maker sell its
cheese. Additionally, we clarified in the report that industry
participants we interviewed that told us the NASS survey made their
business more complicated were referring to short-term problems in milk
pricing due to the use of the NASS survey and the corresponding time lag.
Moreover, the time lag is one reason why California does not rely on the
NASS survey of cheese prices. Finally, USDA comments included an overview
of minimum milk prices and the manufacturing plant relationship with the
FMMO.
As agreed with your office, unless you publicly announce the contents of
this report earlier, we plan no further distribution until 14 days from
the report date. At that time, we will send copies of this report to the
appropriate committees. We will also send copies to the Chairman of CFTC,
the Secretary of Agriculture, and the Managing Director, Regulatory
Counsel of CME. We also will make copies available to others upon request.
In addition, the report will be available at no charge on the GAO Web site
at http://www.gao.gov.
If you or your staff have any questions concerning the report, please
contact me at (202) 512-8678 or [email protected], or John Wanska,
Assistant Director, at (312) 220-7628 or [email protected]. Contact points
for our Offices of Congressional Relations and Public Affairs may be found
on the last page of the report. Key contributors to this report are listed
in appendix III.
Orice M. Williams
Director, Financial Markets and Community Investment
List of Congressional Requesters
The Honorable Arlen Specter
Ranking Member
Committee on the Judiciary
United States Senate
The Honorable Hillary Rodham Clinton
United States Senate
The Honorable Russell D. Feingold
United States Senate
The Honorable Herb Kohl
United States Senate
The Honorable Charles E. Schumer
United States Senate
Appendix I: Scope and Methodology
To review the structure and operations of the Chicago Mercantile Exchange
(CME) spot cheese market, we obtained and analyzed information about CME,
including internal rules and procedures that govern the market. We
compared this information to the National Cheese Exchange's (NCE) rules
and procedures, as well as to federal and academic analyses of the
structure and operations of NCE. We obtained and reviewed industry and
academic literature regarding market structure. To analyze concerns about
price manipulation, we reviewed existing studies that assessed market
characteristics associated with price manipulation. In addition, we
obtained and analyzed spot cheese market trading data provided by CME. To
assess the reliability of the CME data, we reviewed the data and
interviewed CME officials, and determined that the data were sufficiently
reliable for our purposes. Using the data provided, we calculated summary
statistics on volume of trading, number of market participants, and the
role of uncovered bids and unfilled offers. We also obtained Commodity
Futures Trading Commission (CFTC) and CME officials' views as well as
those of market participants and members of the cheese and dairy industry
on the potential for price manipulation at the CME spot cheese market and
NCE. We did not attempt to determine whether manipulation has occurred on
the CME spot cheese market; instead, we identified the characteristics of
this market that are consistent with those of markets considered
susceptible to price manipulation.
As a part of our review of market monitoring and oversight, we obtained
and analyzed information about CFTC, CME, and other oversight and
enforcement organizations on their role in monitoring the CME spot cheese
market. In addition, we interviewed officials from CFTC's Division of
Market Oversight, Division of Enforcement, and Office of General Counsel
to obtain information about CFTC's role in the CME spot cheese market. We
also interviewed CME officials from its Legal and Market Regulation
Division, Corporate Development Division, and Products and Services
Division to discuss CME's oversight of the CME spot cheese market.
To review how the CME spot cheese market impacts federal minimum milk
prices, we obtained and reviewed federal laws and United States Department
of Agriculture (USDA) regulations governing the federal milk pricing
formulas. We also reviewed academic analysis of the role the spot cheese
market has in milk pricing. In addition, we interviewed officials from
USDA's Agricultural Marketing Service and National Agricultural
Statistical Service as well as numerous academics who study issues of
dairy policy. We also interviewed market participants and members of the
cheese and dairy industry on the relationship between the CME spot cheese
market and minimum federal milk prices. Members of the dairy and cheese
industry included cheese manufacturers, dairy cooperatives, processors of
cheese, and milk producers.
Appendix II: Comments from the Department of Agriculture
Appendix III: GAO Contact and Staff Acknowledgments
(250314)
GAO contact
Orice Williams, (202) 512-8678, or [email protected]
Staff Acknowledgments
In addition to those individuals named above, John Wanska, Assistant
Director; Marta Chaffee; Emily Chalmers; Jay Cherlow; Alison Martin; Marc
Molino; Andy Pauline; and Paul Thompson made key contributions to this
report.
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[26]www.gao.gov/cgi-bin/getrpt?GAO-07-707 .
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Highlights of [27]GAO-07-707 , a report to congressional requesters
June 2007
SPOT CHEESE MARKET
Market Oversight Has Increased, but Concerns Remain about Potential
Manipulation
The Chicago Mercantile Exchange (CME) is home to the spot cheddar cheese
market, which impacts the prices of virtually all cheese traded in the
United States, producer milk prices, and milk futures contracts. The spot
cheese market, formerly the National Cheese Exchange (NCE) in Wisconsin,
has been and continues to be the subject of concerns about price
manipulation. GAO was asked to examine (1) the market's structure and
ongoing concerns about price manipulation; (2) market oversight and
efforts to address potential manipulation; and (3) how the market impacts
federal milk pricing. In response, GAO compared the markets at NCE and
CME, analyzed trading data, collected information about the Commodity
Futures Trading Commission's (CFTC) oversight, and met with industry
participants, academics, and agency officials.
[28]What GAO Recommends
GAO recommends that the U.S. Department of Agriculture (USDA) seriously
consider all industry proposals, including one to eliminate the National
Agricultural Statistical Service (NASS) survey of cheese prices, in the
minimum federal milk pricing formula. If USDA continues to use the survey,
GAO recommends that USDA audit the survey data. In written comments, USDA
agreed to audit the survey data. USDA did not agree to proactively
consider a proposal to eliminate the survey but would give due
consideration to all industry proposals.
Because the CMEspot cheese market remains a market in which few daily
trades occur and a small number of traders account for the majority of
trades, questions exist about this market's susceptibility to potential
price manipulation. The structure and operations of the CME spot cheese
market are comparable to NCE's, including trading rules, products traded,
and market participants. However, there are differences, including daily
trading at CME versus once-a-week trading at NCE.
CFTC and CME provide oversight of the CME spot cheese market that did not
occur on NCE. Both engage in activities that may detect and deter
potential price manipulation at this market. CFTC, as part of its
responsibility for regulation of commodity futures markets, monitors cash
markets, including the spot cheese market, and can act on indications of
manipulative activity. In addition, CME conducts daily surveillance and
regularly reviews trading data and market trends. According to CFTC and
CME officials, they have both made efforts to address allegations of the
potential for price manipulation by examining the activities of
participants in the spot cheese market. As of June 2007, none of these
reviews have led to an instance of CFTC taking legal action against a
market participant.
CME's spot cheese market impacts federal minimum milk pricing through the
NASS survey of cheddar cheese prices, which as shown below are highly
correlated to the CME cheese prices. CME spot cheese prices are used to
set long-term contracts, which are then captured by the NASS survey of
cheese prices--a significant commodity component in USDA's minimum milk
pricing formulas. According to USDA, the agency uses the survey, in part,
because it captures more transactions than occur at the CME spot cheese
market. However, in addition to largely capturing CME price data, it
introduces a 1- to 2-week time lag between when data are reported by NASS
and when certain transactions captured in the survey occur. Moreover the
survey is not currently audited to ensure the accuracy of the information.
These factors may contribute to milk prices paid by dairy market
participants that are either not completely accurate or not current.
CME Spot Cheese Market and NASS Cheese Survey Block Cheese Prices
References
Visible links
19. http://www.gao.gov/cgi-bin/getrpt?GAO-05-50
20. http://www.gao.gov/
21. http://www.gao.gov/
22. http://www.gao.gov/fraudnet/fraudnet.htm
23. mailto:[email protected]
24. mailto:[email protected]
25. mailto:[email protected]
26. http://www.gao.gov/cgi-bin/getrpt?GAO-07-707
27. http://www.gao.gov/cgi-bin/getrpt?GAO-07-707
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