Commodity exchanges are starting to resemble casino gambling halls rather than quality hedging places for buyers and sellers. Independent elevators, and a lot of businesses that forward contracts in large numbers, are getting squeezed.
Here's how everything is supposed to work between a producer and an elevator. Say soybean futures reach $8 in January. A grower calls his local elevator and books the price. If basis is a dollar, the contract is worth $7 a bushel to the grower. The elevator will simultaneously sell a futures contract for $8 a bushel at the Chicago Board of Trade.
Normally the elevator can ride this hedge position until delivery time. But if prices start rising, the elevator might have to make margin calls equal to the rise in price. For example, if the futures contract is at $8 per bushel and the price goes to $13, CBOT can call the elevator for a $5 per bushel margin call for everything booked at $8.
If an independent elevator is liquid enough, it can ride out the storm long enough to unwind the hedge. At that time, it buys its position back at $13 per bushel, and sells cash at $13. The elevator puts a dollar in its pocket from the basis. Under this scenario, it loses $5 in the futures (from selling at $8 and buying back at $13) but picks up $5 in the cash (buying for $8 and selling for $13).
But when the markets head toward outer space as they have recently, small elevators with hundreds of contracts can be required to put so much money into margin calls that their lenders simply have to say no. In fact, some banks could make elevators close their positions, probably putting them out of business.
Another impact is that some warehouses or elevators may choose to avoid this risk altogether and simply stop booking if they cannot continue to pay margin calls.
Another problem is the lack of convergence between the futures and cash markets. Because of heavy investment by speculators — gamblers actually is a better word — in the commodity exchanges, the cash price is nowhere the futures price, and the gap may not be close by harvest time, depending on the timing and level of investment by speculators.
“The emotion in the markets and the hedge funds has taken the markets to new highs so fast that the cash marketplace has had a difficult time reacting to that,” said Carl Brothers with Riceland Foods in Stuttgart, Ark. “It's terrible when you think you'd like to see the market go down some, but if it keeps running, it can put our growers' ability to book forward at risk.”
Recently, the Commodity Futures Trading Commission announced that it will convene a public meeting to discuss recent disruptions affecting the markets. Hopefully, the discussion can start a process to restore the function of the commodity markets.