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Wheat Cash-Futures Convergence Improves

When the Commodity Futures Trading Commission's Agricultural Advisory Committee met on August 5, one of the topics discussed was the convergence of wheat futures and cash prices at the expiration of the contracts. In the past several years, the two prices of the same underlying wheat have on occasion diverged significantly.

The droughts and crop failures in Russia and other countries are seen as having an impact on the spread, but the effect of the Russian export ban was not studied because it is new.

To improve cash-futures convergence at futures expiration, CME Group instituted variable storage rates starting with the July 2010 CBOT wheat futures contract. David Lehman of CME Group said futures and cash wheat prices came together at the expiration of recent contracts but it is too early to tell the impact of variable storage rates.

The spread may have narrowed due to fundamental factors and the addition of new delivery points. Market changes that may have had an impact include the droughts in wheat growing areas in Russia and other countries by the Black Sea. There has also been an increase in trading volume, up 20% from a year ago, and open interest, up 47%.

Warehouse Linkage

Another presenter at the meeting, Nicole Aulerich from the CFTC Office of the Chief Economist, said warehouse receipts act as the linkage between the futures and the cash market. At delivery the seller of a futures contract delivers to the buyer a warehouse receipt that represents the grain in storage.

A special feature of warehouse receipts gets in the way of convergence- buyers can hold a receipt indefinitely, as long as they pay the storage cost. The incentive is to hold on to the receipt and not exchange it for the underlying wheat in the cash market, said Ms. Aulerich. The holder of the receipt can pay storage fees, roll forward the contracts and get a return.

This drives a wedge between cash and futures markets, she said. The storage cost is 4.5 cents per bushel, paid monthly. With the new variable schedule, the storage rate is adjusted to the nearby spread.

Mr. Lehman said it will be interesting to observe how variable storage rates work and CME continues to monitor the contract closely.

David Amato of CFTC Division of Market Oversight said the side effects of poor convergence include weakened price discovery and hedge effectiveness. But he finds that convergence has improved over the last year.

Index Funds

Mr. Amato disputed that large traders caused the problem, a claim that has made news headlines. He presented data that suggests large traders, in particular index funds, are not the cause of divergence. Index funds' share of open interest in Chicago wheat futures fell at the time the contract was not converging to the cash price.

Officials stressed the importance of the issue, which shows up in both the Chicago and Kansas City futures contracts. "This lack of convergence has significant implications for hedgers and goes to the core of our markets," said CFTC chairman Gary Gensler. "Without convergence, hedgers lose confidence in the marketplace."

Besides wheat price convergence, at the August meeting there were discussions of the ICE Futures US cotton contract and price reporting in livestock markets. In addition, Mr. Gensler pointed out that the CFTC is working to implement the Dodd-Frank financial regulation bill, which will extend regulation to over-the-counter derivatives such as swaps.

He said he is particularly interested in hearing the views of the Agricultural Advisory Committee regarding how rules should be written for agricultural swaps.