Not So Krafty?
The CFTC has filed a complaint against Kraft and Mondelez Global, accusing the companies of manipulating the December, 2011 CBT Wheat Futures Contract. A few comments, based on what is laid out in the complaint (and therefore not on a full evaluation of all relevant facts and data):
- A trader executes a market power manipulation (i.e., a corner or a squeeze) by taking excessive, and uneconomic, deliveries on a futures contract. This causes the calendar spread to increase, and the basis at locations where delivery does not (or cannot) occur to fall. The complaint alleges that Kraft took large deliveries. The relevant calendar spread (December-March) rose sharply, and according to Kraft emails cited in the complaint, the basis at Toledo declined. Thus, the facts in the CFTC complaint support a plausible allegation that Kraft and Mondelez executed a market power manipulation/corner/squeeze.
- A cornerer takes uneconomic deliveries. That is, the deliveries taken are not the cheapest source of the physical commodity for the cornerer. The complaint does not provide sufficient detail to determine with precision whether this was the case here (but discovery will!), but it does include circumstantial evidence. Specifically, Kraft took delivery on the Mississippi, whereas it needed physical wheat at its mill in Toledo. Further, Kraft did not use most of the wheat it bought via delivery. Instead, it sold it, which is consistent with “burying the corpse.” In addition, given cash bids in Toledo and the futures price at which the defendants took delivery, it is highly likely that it was cheaper for Kraft to buy wheat delivered to its mill in Toledo than it was to take delivery (at an opportunity cost equal to the futures price) and pay load out and freight costs to move the wheat from the Mississippi to Toledo. Again, though, the complaint doesn’t provide direct evidence of this.
- A cornerer liquidates a large fraction of its futures position: whereas it loses money on the deliveries it takes, it makes money by liquidating futures at a super competitive price. Kraft liquidated more than half its futures position. This provides further evidence that it did not establish its futures position as a means of securing the cheapest source of cash wheat, and is consistent with the execution of a corner/squeeze.
- A processor hedging anticipated cash purchases doesn’t buy calendar spreads. The complaint quotes an email stating that Kraft did.
- One clunker in the complaint is the allegation that Kraft’s actions “proximately caused cash wheat prices in Toledo to decline.” Market power manipulation when Toledo is not the cheapest to deliver location (as was evidently the case here, as deliveries did not occur in Toledo) would be expected to reduce the Toledo basis (i.e., the difference between the Toledo cash price and the December futures price), and there is some evidence in the complaint that this occurred. But this is different from causing the flat price of wheat to decline, which is what the CFTC alleges. Any coherent theory of market power manipulation implies that a corner or squeeze would increase, or at least not reduce, the cash price at locations where delivery does not occur, but that the rise in the cash price at these locations is smaller than the rise in the futures price (and in the cash price at the delivery location). This results in a compression of the basis, but a rise (or non-decline) in flat prices.
- In sum, the complaint presents a plausible case that Kraft-Mondelez executed a market power manipulation.
- But the CFTC doesn’t come out and allege a corner, squeeze, or market power manipulation: these words are totally absent. Instead, the agency relies on its shiny new anti-manipulation authority conferred by Frankendodd under section 6(c)(1) of the Commodity Exchange Act, and CFTC Rule 180.1 that it adopted to implement this authority. This is essentially a Xerox of the SEC’s Rule 10b-5, and proscribes the employment of any “deceptive or manipulative device.” That is, this is basically an anti-fraud rule that has nothing to do with market power and therefore it is ill-adapted to reaching the exercise of market power.
- The CFTC no doubt is doing this because under 6(c)(1) and Rule 180.1 the CFTC has a lower burden of proof than under its pre-Frankendodd anti-manipulation authority. Specifically, it does not have to show that Kraft-Mondelez had specific intent to manipulate the market, as was the case prior to Dodd-Frank. Instead, “recklessness” suffices. Further, it does not have to demonstrate that the price of wheat was artificial. In my view, the straightforward application of economics permits determination of both specific intent and price artificiality, but earlier decisions like Indiana Farm and in re Cox make it difficult to for the CFTC to do so. Or at least that’s what CFTC believes.
- Although I understand the CFTC’s choice, it has jumped from the frying pan into the fire. Why? Well, to mix metaphors, there is a square peg-round hole problem. As I’ve been shouting about for years, fraud-based manipulations and market power manipulations are very different, and using a statute that targets fraudulent (“deceptive”) actions to prosecute a market power manipulation is likely to end in tears because the legal concept does not fit the allegedly manipulative conduct. The DOJ learned this to its dismay in the Radley case (which grew out of the BP propane corner in 2004). Even though BP executed a garden variety corner, the DOJ alleged that the company engaged in a massive fraud. Judge Miller found this entirely unpersuasive, and shot down the DOJ in flames. The CFTC risks the exact same outcome. Tellingly, it asserts in a conclusory fashion that Kraft-Mondelez employed a “deceptive or manipulative contrivance” but doesn’t say: (a) what that device was, (b) how Kraft’s taking of a large number of deliveries deceived anyone, (c) who was deceived, and (d) how the deception affected prices.
It will be interesting to see what happens going forward. The CFTC is obviously using this as a test case of its new authority. Perhaps it thinks it is being crafty (or would that be Krafty?) but I fear that by using a law and rule targeted against fraudulent conduct to prosecute a market power manipulation, the agency will just be finding a new way to screw up manipulation law, thereby undermining, rather than strengthening, deterrence of market power manipulation.
So will the Beastie Boys be singing about the CFTC? We’ll see, but I’m not hopeful.
I am not fully convinced by points 1,2,3.
=>Toledo wheat cash bids are notoriously illiquid, personally I found it difficult to entirely trust the data.
=> The position was opened during October, the actual crop size is not known and we are at the expiration of the December contract e.g If the size of the crop was actually smaller than expected, it’s normal that the DEC/MCH flattens.
=> I also reckon that it is normal for Kraft to be LONG December to pre-hedge their purchases, the CFTC would have to review the hedging policy.
=>Kraft bought something like 15 million bushels of December 2011 wheat futures, and sold a similar offsetting amount of March 2012 wheat futures, at a spread of 35 cents.
Generally it is allowed, encouraged even, for a big market participant to hide its intentions. In the name of the game they will try to hide the position/intentions to the market with a spread.
Market was in Contanto and When Kraft indicated its intention to actually take delivery, it changed that dynamic. It created demand but from what I understand they booked a profit on the 24c profit on the spread, not something illegal if they can support their view with documentation and Pirrong: the cash and futures converged at the end of december. see chart http://wp.me/p3k7lL-2Ry, I don’t see an evident distortion between the cash and the futures.
It is quite bizarre the an end-user is accused to manipulate the market and Prices shooted higher. Normally they would prefer to chop the prices down. It’s their job to buy as cheap as possible.
Rule 180.1 opens a pandora box, crackdowns on non-traders and companies outside the financial banking system using derivaties markets.
Comment by Simon Jacques — April 6, 2015 @ 1:26 am
@Simon-Items 1, 2, and 3 are the basics of market power manipulation. Large deliveries at uneconomic prices, burying the corpse, increase in the calendar spread, fall in the basis. Kraft ticked all the boxes.
In particular, making a profit on the spread is *NOT* legal if one causes the spread to widen by taking excessive deliveries.
Um, SRW is winter wheat, meaning that the new crop is in July. No information really about crop size arrived during the period of time the spread rose.
No disputing that Kraft is normally a long hedger. The relevant issue is whether it acted in a commercially reasonable matter for a long hedger. The fact it was long the calendar spread is inconsistent with it hedging anticipated cash needs. Moreover, normally hedgers like Kraft roll their hedges, or reduce them as they fill their cash needs. That’s what Kraft normally did, and didn’t do in this case. Further, it took delivery of wheat that was out-of-position relative to its processing facilities, and which didn’t meet its quality standards. It then turned around and sold it. That’s how a cornering commercial behaves, not a long hedger.
I understand perfectly the issues with Toledo cash bids, having studied and written about this issue 20+ years ago. This is why I was circumspect in making any conclusions about cash prices. However, in my experience Toledo bids are not 20/30 cents away from the market, as would be necessary to make MS River wheat a cheap source of cash for Toledo processing.
I am perfectly fine with commercial secrecy. That’s not the issue here.
Convergence is another red herring. Futures converges to CTD cash even in cornered markets. The problem is that prices converge at an artificially high level.
The fact that processors should want to buy cheap is exactly why Kraft’s conduct in this case is suspicious. Delivery wheat was not the cheap source of cash wheat for its processing operations. What’s more, they had a strong economic interest in causing the spread to increase. They profited from prices “shooting higher.” So your point cuts exactly the other way.
I agree that 180.1 opens a Pandora’s Box. That’s one of the main points of the post: that’s the the square peg-round hole point. I have also been very critical of Rule 180.1-type regulations as applied to market power manipulation. I’ve been writing about this issue for years.
Hi Professor,
Conditions for proving market manipulation under
the CEA
(1) Price of the manipulated contract was “artificial” (known as “price artificiality”)
(2) The accused had the ability to cause the artificial price
(3) The accused caused the price to be artificial
(4) The accused acted with intent to cause the price to be artificial (to be proven with emails, telephone conversations…)
Pirrong, Energy Market Manipulation: Definition, Diagnosis
Deterrence, in the Energy Law Journal, 2010).
• Given prompt-end of the curve is more liquid and that SRW is planted during fall, I thought that some information about the new crop arrived during this period.
• The point is whether it acted in a commercially reasonable matter for a long hedger. (Reasonably)… A long hedger should not be immobile: the curve flattened and Kraft has taken advantage of it to help (swapping) others to fill their orders and nicely exit their position at a profit.
• It now seems to me that they bought at one location, and sell at another and combined it with a spread.
• They took delivery of a batch not meeting their quality standards, ok but it’s quite normal to flip some grain no.1 no.2 no.3 processed it.
Also a comment from an experienced Canadian Trader: In order to get the full story, one has to go back to 2010.
In 2010 the CBOT introduced the VSR into the CBOT wheat contract.
It served to allow the storage component of carrying charges to “float”, hence the term “Variable”. This was a novel concept when introduced given that storage rates are generally presented at fixed levels in the contract specifications of a futures contract.
In theory, the wheat spreads could now move to a larger contango in perpetuity. Given that the composition of the open interest contained a large speculative long position at the time of introduction, the VSR had the effect of working against the long (the market knew the long was not going to stand for delivery) and in favour of the short… The long, whether commercial or speculative could not quantify its risk given that the spreads could continue to move to contango in perpetuity. And this is what happened.
By August 2011, the SeptDec spread traded out to 50 cents. If that were to be extrapolated over the course of a year it would mean a long would increase its purchase price by $3.00/year. That proved to be unsustainable for obvious reasons. Finally, KRAFT stepped in and stood for delivery against the Dec. Up to this point there was no/little threat of standing for delivery. KRAFT FILLED A VOID IN THE MARKET THAT WAS LACKING FROM THE INCEPTION OF THE VRS, albeit by exceeding position limits.
From my perspective, Kraft probably played an important role in keeping the CBOT wheat futures a viable contract. Unfortunately it is being characterized as manipulating the contract. Just an opinion.
Thank you
Simon Jacques
@freighttrader
Comment by Simon Jacques — April 6, 2015 @ 2:55 pm
SWP & SJ:
Thank you for allowing Vlad to be a fly on the wall.
Absolutely fascinating.
VP VP
Comment by Vlad — April 9, 2015 @ 7:53 pm
I work at Toledo Flour Mill.
There is lots of unsafe and scheming that goes on. George Haritatos had an “A” team and they received large bonuses for “saving money”. Funny thing is George was plant manager and he along with his ” A” team sidekicks all have been promoted and moved to various plants. No one has a clue outside the plants the conspiracy and illegal activities. What you hear is only the surface.
Comment by Toledo worker — April 23, 2015 @ 3:00 pm