How sophisticated traders exploit an obscure USDA rule change to get rich, fleece farmers, and drive up food prices
By Lina Khan
While the activities of the Agriculture Department don’t always garner a lot of attention, a highly questionable decision it recently made to help wealthy speculators could, over time, cost anyone who buys food. But while the decision — a big win for high-frequency traders at the expense of farmers, food companies, and the public — is consequential, its effects have hardly been reported.
First, some history is in order. In 1905, a government statistician was caught leaking numbers related to the cotton crop. While Agriculture Department employees finalized statistics in a locked room, the informer would walk over to the window and raise or lower the blinds, depending on whether the forecast was above or below a predetermined figure. His accomplice outside would then dart off to trade on the information before it was publicly released. The duo netted several hundred thousand dollars this way until the scandal broke.
The government responded forcefully. President Roosevelt ordered his administration to launch a full investigation into the affair and to prosecute any official involved. The House and Senate both unanimously passed a bill making premature disclosure of agriculture statistics a crime. Nobody needed to argue that the scheme had inflated cotton prices or swindled the public. The issue was fairness. As Agriculture Secretary James Wilson wrote, “We take the ground here that nothing goes out unless it goes to the whole people. We have no favorites.”
In the century since, officials have heeded Wilson’s rule, often stringently; in the 1940s a New York Times reporter likened the protections to those around an atom bomb. Today elaborate security regimes continue to surround routine releases of government numbers on crops, as well as other figures like unemployment reports.
But recently a combination of corporate decisions and fumbling regulators has undone the equal access to this information, which our predecessors so carefully crafted. The new arrangement advantages nobody but the same sophisticated speculators that officials suspect might be illegally manipulating prices. And yet, despite vigorous complaints from the people who actually grow and use our grains, regulators have — for all intents — abandoned this century-old policy.
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The recent changes mainly affect the market for grain futures. This is where farmers and major buyers of crops (known in market parlance as “end users”) buy contracts that allow them to “hedge” against the risk that prices might suddenly soar or plummet, due to, say, a drought or an outbreak of pests. Since no farmer or buyer knows how much total corn or wheat is being produced across the nation as a whole, these end users base their hedges partly on what the government estimates. The prices on these grain futures markets, in turn, help determine the price we pay for food.
Until recently, the Agriculture Department released its numbers at 7:30 a.m. Central Time, two hours before the main market for grain trading opened in Chicago. Farmers and other end users then had two hours to read the report, figure out what trades to make and call their broker to place their orders. Speculators — who trade futures contracts to benefit from price differentials and thereby help lubricate the market — also studied the numbers and predicted which direction orders would go. All trades — whether placed by a wheat farmer in Nebraska or a hedge fund manager in New York — waited in line alongside one another until 9:30 a.m., when they would be registered at the same time.
The market — run by the Chicago Mercantile Exchange — would then close at 1:15 p.m. to allow morning trades to be settled. It would reopen for a night session that ran from 6:00 p.m. to 7:15 a.m. to accommodate traders in Asia and Europe.
Last May, the CME extended its trading day from 17 hours to 21 hours, eliminating the two-hour break in the morning when USDA released its reports. Suddenly, farmers and end users no longer had time to understand the information before trading began. Algorithmic traders, armed with a variety of technologies that allow them to gather and process information almost instantly, were left free to place their bets long before any regular grain traders had time to open, let alone read, the report.
“People who are out trying to feed cattle don’t have access to high-power computers for trading in milliseconds,” said Mark Nelson, commodities director at the Kansas Farm Bureau. “It creates an uneven playing field.”
Geography worsens the disparity. Slower Internet speeds in rural parts of the country intensify millisecond disadvantages into minutes. Many traders say accessing in Iowa or Kansas numbers released in Washington, D.C., often takes five minutes. (If USDA servers are overwhelmed with traffic, it can take up to 20 minutes.) In an age where companies spend millions of dollars to place themselves close to exchange servers to win a millisecond edge, a five-minute lag is eternal.
“The information isn’t available to all market participants at the same time. So there are people who have an advantage over others,” said Tracy Gathman, an Iowa broker who trades for commercial grain elevators and mills.
End users also complain that the change encourages hasty uninformed activity by high-frequency traders, who use sophisticated algorithms to make millions of rapid short-term bets per second and can exacerbate volatility. End users generally dislike volatility because sharp frenetic price swings heighten their financial risk and can erode trust in markets, which they rely on for information to price their crops. It can also raise their cost of business. High-frequency traders, however, swarm to greater volatility, as every tiny price differential is an opportunity to slice off a quick profit.
The new timings coincide with several years of anomalous price movement following grain reports. USDA estimates now regularly diverge from what grain traders and analysts expect, which means markets react sharply to the government figures. Eleven of the last 13 crop reports have generated significant price movements. The March report spurred the largest two-day drop of corn prices in history. Grain traders blame the wider divergence on various factors — complications from corn use for ethanol, for example, or poor survey responses from farmers — and agree that the trend has made reports all that more anticipated and reactions all that more dramatic.
Algorithmic and high-frequency traders have been active in the grain futures markets for several years. But until now government reports was one place nobody had a head start.
The effects are real and they can be big. Gathman said within the first five minutes of an April report he watched corn prices swing 32 cents, a huge spread. “While the market was doing that, we had still not seen the reports,” he said.
It’s not just rural traders who criticize the new arrangement. “It’s an idiotic gimmick and counter-productive,” said Stanley Bedows, vice president of Rand Financial, which trades for large institutional and commercial businesses out of Chicago. “All [the change] does is let the algo[rithmic] traders run the market up and run it back down in response to headline numbers,” he said.
Michael Greenberger, a law professor at the University of Maryland and former director of the division of Trading and Markets at the Commodities Futures Trading Commission, says the change further empowers traders to treat grain markets like “casinos,” and in the long-run the public pays. “It creates biases in markets that drive prices up,” he said. “The average consumer is completely undermined in this entire process.”
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After the changes, end users complained to USDA and to the Commodities Futures Trading Commission, which oversees CME and approved its new hours.
Last May USDA reviewed its release times in response to the expanded trading day and invited market participants to submit their preferred times. A significant majority of the public comments decried the new arrangement, and many urged USDA to change its report releases to when trading at CME is closed. The major grain trade associations also noted that unless the exchange halts trading around the report release, end users would not have equal access.
Last September USDA announced that as of 2013 it would release reports at midday, when the market is open and trade volume is highest. “The shift to a noon release allows for the greatest liquidity in the markets, provides the greatest access to the reports during working hours in the United States, and continues equal access to data among all parties,” USDA said. CFTC issued no public comment.
Grain traders and brokers say the noon timing does nothing to fix the problem. Worse, they say, it effectively endorses the arrangement, which creates hasty uninformed activity that benefits only algorithmic traders.
“Both CFTC and USDA completely disregarded the requests of the grain trade, the actual end users of these markets,” said Gathman, who submitted a comment on behalf of the Agribusiness Association of Iowa. “It’s frustrating; it’s like everything fell on deaf ears.”
USDA spokeswoman Susan King said the agency read public comments closely. The CFTC declined to comment.
In April CME curtailed trading hours in response to complaints that trading volume spread across more hours diminished liquidity, which hurts high-frequency traders as well as grain traders and nonautomated speculators. To invigorate volume further CME also introduced a 45-minute pause from 7:45 to 8:30 a.m.
Grain traders say releasing USDA reports during this “biscuit break” could help level the playing field. But USDA is not considering another switch. “These markets are changing their times all the time, and we can’t keep reacting to that,” King said.
CME says it would introduce a pause around the current report releases, but only if all other grain exchanges did, too. The Atlanta-based InterContinental Exchange, its primary rival, says it has no plans to halt trading.
The exchanges operate as self-regulating organizations, which have the power to create and enforce industry standards. The CFTC oversees the exchanges to ensure their standards serve the interests of end users and the public.
Gathman, the Iowa broker, says that if the CME and other markets are not able to police themselves to fix this issue, “then CFTC has to step in and make the market fair to all participants.”
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For many grain traders, the changes only confirm their belief that CME is making money at their expense by favoring the interests of high-frequency traders. Last year a survey by Save the Floor, a group of floor traders and brokers, found 87 percent of 500 market participants agreed that the “[Chicago Board of Trade] CME Group has abandoned farmers, ranchers, producers, grain elevators and end users in favor of big banks and electronic high-speed trading firms.” One responder added, “As a grain farmer, cattle producer and market maker in the cattle and hog futures, I find the actions of the exchange despicable. They have truly lost their way and forgot what these markets were all about in the first place.”
CME, for its part, says its actions reflect its struggle to balance the wildly diverse interests that meet on the futures market. CME, for instance, initially expanded its hours last May to ensure it did not lose business to ICE, its rival that trades for 22 hours per day and last year introduced grain futures contracts, replicas of CME’s products. The exchange says it considered the full range of customer perspectives when deciding its new hours.
But as a for-profit company, it’s hard to imagine that the CME’s own interests do not play some role in its decisions.
This is a relatively new — and little studied — factor. From its birth in 1898, CME operated as a member-owned exchange, a nonprofit organization that ran on membership fees, as did most exchanges during the last century. CME reorganized as a corporation only in 2000, then went public in 2002. In 2007, it acquired the Chicago Board of Trade, where grain contracts had always traded. Today, it derives revenue from both the size and volume of trades executed on its platform. High-frequency traders generally dwarf other traders in volume, and chase markets for prospects of volatility.
How high-frequency traders affect markets remains controversial. Advocates say they create a more efficient market; critics say they drive away real buyers and sellers. A study by the former chief economist at CFTC last year concluded that high-frequency traders profit at the expense of ordinary traders. After news of the research became public, CME accused CFTC of illegally sharing its proprietary data. CFTC has since suspended the program that produced the research.
CFTC has struggled to adapt policies to high-frequency trading. Incidents like the 2010 “flash crash” and the recent AP Twitter hack have directed public attention to the new dangers these “algobot” traders pose to market stability and have increased pressure on regulators to introduce some level of supervision.
In other marketplaces, directors are moving towards placing “speed limits” on trading to limit the advantages offered by raw technology. One proposed system would bundle together incoming orders every few milliseconds and execute them in a random order. While such a plan would do little to help grain traders who lag by minutes, the idea reflects a growing concern that speed advantages are unfair and that the ongoing technological arms race hurts markets.
Germany recently passed a law to curtail high-frequency trading, and its Parliament considered excluding certain commodities from high-frequency trading altogether. “In this way it could be ensured that the biggest risks to the economy which could result from high-frequency trading … are limited,” the Parliament said. High-frequency trading accounts for around 40 percent of total trading in Germany, compared to around 60 percent in the U.S. futures market. Australia, Hong Kong and Singapore are also considering regulations.
For grain traders the disturbance posed by the new arrangement follows two decades over which corporate decisions and technological advances have transformed their business. Most generally accept the need to adapt their ways to an evolving world, but have watched many of these changes with ambivalence, suspecting that bigger and richer interests use the rise of new technologies as a way to subvert traditional protections.
With this latest change, they fear one of the most basic protections — dating back more than a century — has been overrun.
Lina Khan reports on the effects of concentrated economic power with the Markets, Enterprise, and Resiliency Initiative at the New America Foundation.