Finally, Someone Connects the Food Dots

Here's just one more dot to connect: the Fed's disastrous monetary policy is the partial cause of food inflation, and thus a trigger for food riots all over the developing world! 

by Ambrose Evans-Pritchard

If you insist on joining the emerging market party at this stage of the agflation blow-off, avoid countries with an accelerating gap between rich and poor. Cairo’s EGX stock index has dropped 20pc in nine trading sessions.

Events have moved briskly since a Tunisian fruit vendor with a handcart set fire to himself six weeks ago, and in doing so lit the fuse that has detonated Egypt and threatens to topple the political order of the Maghreb, Yemen, and beyond.

As we sit glued to Al-Jazeera watching authority crumble in the cultural and political capital of the Arab world, exhilaration can turn quickly to foreboding.

This is nothing like the fall of the Berlin Wall. The triumph of secular democracy was hardly in doubt in central Europe. Whatever the mix of aspirations of those on the streets of Cairo, such uprisings are easy prey for tight-knit organizations – known in the revolutionary lexicon as Leninist vanguard parties.

In Egypt this means the Muslim Brotherhood, whether or not Nobel laureate Mohammed El Baradei ever served as figleaf. The Brotherhood is of course a different kettle of fish from Iran’s Ayatollahs; and Turkey shows that an ‘Islamic leaning’ government can be part of the liberal world – though Turkish premier Recep Tayyip Erdogan once let slip that democracy was a tram “you ride until you arrive at your destination, then you step off."

It does not take a febrile imagination to guess what the Brotherhood’s ascendancy might mean for Israel, and for strategic stability in the Mid-East. Asia has as much to lose if this goes wrong as the West. China’s energy intensity per unit of GDP is double US levels, and triple the UK.
The surge in global food prices since the summer – since Ben Bernanke signalled a fresh dollar blitz, as it happens – is not the underlying cause of Arab revolt, any more than bad harvests in 1788 were the cause of the French Revolution.
Yet they are the trigger, and have set off a vicious circle. Vulnerable governments are scrambling to lock up world supplies of grain while they can. Algeria bought 800,000 tonnes of wheat last week, and Indonesia has ordered 800,000 tonnes of rice, both greatly exceeding their normal pace of purchases. Saudi Arabia, Libya, and Bangladesh, are trying to secure extra grain supplies.
The UN’s Food and Agriculture Organization (FAO) said its global food index has surpassed the all-time high of 2008, both in nominal and real terms. The cereals index has risen 39pc in the last year, the oil and fats index 55pc.
The FAO implored goverments to avoid panic responses that “aggravate the situation”. If you are Hosni Mubarak hanging on in Cairo’s presidential palace, do care about such niceties?
France’s Nicolas Sarkozy blames the commodity spike on hedge funds, speculators, and the derivatives market (largely in London). He vowed to use his G20 presidency to smash the racket, but then Mr Sarkozy has a penchant for witchhunts against easy targets.
The European Commission has been hunting for proof to support his claims, without success. Its draft report – to be released last Wednesday, but withdrawn under pressure from Paris – reached exactly the same conclusion as investigators from the IMF, and US and British regulators.
“There is little evidence that the price formation process on commodity markets has changed in recent years with the growing importance of derivatives markets”, it said.
As Jeff Currie from Goldman Sachs tirelessly points out, future contracts are neutral. For every trader making money by going long on wheat, sugar, pork bellies, zinc, or crude oil, there is a trader losing money on the other side. It is a paper transfer between financial players.
You have to buy and hoard the vast amounts of these bulk commodities to have much impact on the price, which is costly and difficult to do, though people do park crude on floating tankers sometimes, and Chinese firms allegedly stashed copper in warehouses last year.
But that is not what commodity index funds with $150bn are actually doing with food, base metals, and energy. Only governments have strategic petroleum and grain reserves big enough to make a difference.
The immediate cause of this food spike was the worst drought in Russia and the Black Sea region for 130 years, lasting long enough to damage winter planting as well as the summer harvest. Russia imposed an export ban on grains. This was compounded by late rains in Canada, Nina disruptions in Argentina, and a series of acreage downgrades in the US. The world’s stocks-to-use ratio for corn is nearing a 30-year low of 12.8pc, according to Rabobank.
The deeper causes are well-known: an annual rise in global population by 73m; the “exhaustion” of the Green Revolution as the gains in crop yields fade, to cite the World Bank; diet shifts in Asia as the rising middle class switch to animal-protein diets, requiring 3-5 kilos of grain feed for every kilo of meat produced; the biofuel mandates that have diverted a third of the US corn crop into ethanol for cars.
Add the loss of farmland to Asia’s urban sprawl, and the depletion of the non-renewable acquivers for irrigation of North China’s plains, and the geopolitics of global food supply starts to look neuralgic.
Can the world head off mass famine? Yes, with leadership. The regions of the ex-Soviet Union farm 30m hectares less today than in the Khrushchev era, and yields are half western levels.
There are tapped hinterlands in Brazil, and in Africa where land titles and access to credit could unleash a great leap forward. The global reservoir of unforested cropland is 445m hectares, compared to 1.5 billion in production. But the low-lying fruit has already gone, and the vast investment needed will not come soon enough to avoid a menacing shift in the terms of trade between the land and the urban poor.
We are on a thinner margin of food security, as North Africa is discovering painfully, and China understands all too well. Perhaps it is a little too early to write off farm-rich Europe and America.

Finance Reform Bill Will Send Terrible Ripples Through Ag Community

This is what happens when politicians run amok! 

GILTNER, Neb.—Farmer Jim Kreutz uses derivatives to soften the blow should the price of feed corn drop before harvest. His brother-in-law, feedlot owner Jon Reeson, turns to them to hedge the price of his steer. The local farmers' co-op uses derivatives to finance fixed-price diesel for truckers who carry cattle to slaughter. And the packing plant employs derivatives to stabilize costs from natural gas to foreign currencies.
Far from Wall Street, President Barack Obama's financial regulatory overhaul, which may pass Congress as early as Thursday, will leave tracks across the wide-open landscape of American industry.
Designed to fix problems that helped cause the financial crisis, the bill will touch storefront check cashiers, city governments, small manufacturers, home buyers and credit bureaus, attesting to the sweeping nature of the legislation, the broadest revamp of finance rules since the 1930s.
Here in Nebraska farm country, those in the business of bringing beef from hoof to mouth are anxious, specifically about the bill's provisions that tighten rules governing derivatives. Some worry the coming curbs will make it riskier and pricier to do business. Others hope the changes bring competition that will redound to their benefit.
"Out here we like to cuss the large banking institutions because of the mortgage mess, but we also know that without them some of these markets don't work," says Mike Hoelscher, energy program manager for AgWest Commodities LLC, a Holdrege, Neb., brokerage that provides derivatives services to the farming industry.

Derivatives are financial instruments whose value "derives" from something else, such as interest rates or heating-oil prices. The first derivatives were crop futures, which appeared in the U.S. at the end of the Civil War and became a standard facet of business for companies across America.
During the financial crisis, they became notorious as American International Group Inc. and others were gutted by bad bets on derivatives linked to bad mortgages.
President Obama and other proponents say the financial overhaul will prevent the kind of reckless lending and borrowing that sank the financial system and left taxpayers with the check. They say non-financial companies are worrying unduly about the derivatives portion of the legislation. The Senate is expected to approve the financial regulatory overhaul on Thursday, sending it to the president.
The full impact won't be known for years, but in Nebraska nerves are already on edge.
Executives at Five Points Bank in Hastings think the new rules on mortgage lending will make the home-loan business less profitable. "When they create a new regulator, it really scares us," says Nate Gengenbach, vice president of commercial and agricultural lending.
Advance America Cash Advance Centers Inc. thinks the new Bureau of Consumer Financial Protection will take aim at the payday-loan business, though it's not clear what steps the agency will take. Advance America's storefront at the Skagway Mall in Grand Island charges an effective 460.08% annualized interest rate on a two-week $425 loan.
But it's the derivatives portion—the part of the bill aimed directly at Wall Street—that might end up touching most lives in rural America.
The new law requires most derivatives transactions be standardized, traded on exchanges, just like corporate stocks, and funneled through clearinghouses to protect against default.
Faced with intense lobbying, Congress partially exempted businesses that use derivatives for commercial purposes. So, farmers and co-ops probably won't face new collateral requirements, for instance—although there remains a dispute over that section of the bill. Those that trade derivatives on regulated exchanges, such as the Chicago Board of Trade, are less likely to see immediate impacts than those conducting private over-the-counter deals, which will face federal regulation for the first time. The goal is to make such deals transparent.
The question for these farmers is whether such rules will make hedging more expensive. Some say new requirements on big players will create higher costs for small players, including the cash dealers will have to put aside to enter into private derivatives transactions. Some brokers think restrictions on big-money banks and investors will drain the amount of money available to the everyday deals farmers favor.
Others predict the opposite effect, pushing money from the private market to the exchanges and creating more competition that will benefit farmers.
Uncertainty reigns in Giltner, a town of 400 residents 80 miles west of Lincoln. At first glimpse, Giltner's landscape seems featureless, a fading horizon of corn and soybeans. But its details are more subtle, including wildflowers and shaded creeks. Everywhere galvanized-steel sprinkler systems crawl across farm fields like giant stick insects.
Mr. Kreutz, an outgoing 36-year-old with a sandy crewcut and sunburned neck, gave up a career in finance and took over the 2,800-acre family farm after his father's death. As he works his fields, he checks the crop futures prices on his smart phone.
Here's how Mr. Kreutz does it: Say in early summer he sees that the price for a Chicago Board of Trade futures contract on corn for delivery later in the year is $3.56 a bushel. If he likes the price, and wants to lock it in, he calls AgWest and sells a futures contract for 5,000 bushels. The futures contract is a derivative in which the price for corn is set now for exchange in the future, though no kernels will change hands. Instead, when the contract nears expiration, Mr. Kreutz and the buyer of his contract will settle—in effect—by check.
By fall, when Mr. Kreutz is ready to deliver his crop to the local co-op, the market price might have fallen by 50 cents. He'll sell his actual corn for that lower amount. But he'll make up the difference through his financial hedge. (Mr. Kreutz buys a new futures contract at the lower price to make good on his earlier promise, making up the 50 cents.) In all, he'll have hit the price target he locked in earlier in the year, minus brokerage fees.
If the price rises during the summer, as it did during the food crisis two years ago, Mr. Kreutz has to pony up extra cash for his broker—a margin call—to maintain his positions. He recoups that by selling his actual corn at a higher price, but has to take a loss to meet the futures contract he signed earlier in the year, missing out on a windfall but ultimately meeting his target price.
Mr. Kreutz does this type of operation dozens of times a year, hedging about 70% of his 345,000-bushel corn harvest.
Such deals ripple through the local economy. When Mr. Kreutz gets a margin call from his broker, he turns to his banker, Mr. Gengenbach, for a loan to cover it. Mr. Gengenbach estimates that one quarter of his farm clients use derivatives.
"Somebody like Jim has a lot of money in his crop out here," says the 37-year-old Mr. Gengenbach. "If he can't protect that, it's not good for us."
Mr. Kreutz's brokerage, AgWest, thinks the new finance law will hurt both firm and farm. If big investors and dealers have to keep more cash on hand, there will be less liquidity in the market and therefore the cost of derivatives will increase, Mr. Hoelscher, the broker said.
A few minutes from the Kreutz family farm are the corrals of Jon Reeson's feedlot. Mr. Reeson, 43, is married to Mr. Kreutz's sister Jane. His feedlot holds as many as 1,500 steer, mostly Black Angus, which grow from 600-lb. calves into 1,300 pounders ready for slaughter.
Mr. Reeson uses derivatives to hedge both the price he pays for feed and the price he gets for selling his steer.

The fattening takes about 7,000 pounds of food for each animal. Mr. Reeson can't count on a favorable price from his brother-in-law's farm, in which he has a stake, so when he sees a feed price he likes, he seals it with a futures contract.
In April, he called AgWest and locked in a price with a futures contract for $95 per hundredweight of cattle. Since then the market price has dropped to $90. If the price stays there until October, he'll have made the right call, earning a higher price than if he'd relied on the market alone. If the price spikes higher, though, he'll miss out on potential gains.
Mr. Reeson is willing to live with that possibility in exchange for locking in a profit or a narrowed loss. Derivatives hedging helped him survive the recession of 2008-2009, when cash-strapped diners avoided steak and the price of beef plunged.
He's watching the new legislation warily and can't yet tell if it will hurt or help.
When his cattle have reached full weight, Mr. Reeson puts them on Roger and Barb Wilson's trucks for the trip to the slaughterhouse. The Wilsons have seven semi tractors and 16 trailers, and one of their biggest costs is diesel fuel to keep the fleet on the road.
In 2004, Cooperative Producers Inc., his local co-op, offered Mr. Wilson a price-protection plan for 10,000 gallons of diesel at about $2.50 a gallon, with 90 days to use it.
CPI had a choice. It could take its chances and hope the price of fuel would drop before Mr. Wilson took delivery on his full order, a windfall for the co-op. If diesel prices jumped, though, the coop would take a bath. "That falls under speculation," says Gary Brandt, CPI's vice president of energy. "But that's not what cooperatives do. That's what Goldman Sachs does."
Instead, CPI hedged on the New York Mercantile Exchange, buying a futures contract on heating oil, a close market substitute for diesel fuel. The co-op goes a step further and hedges also the difference between the prices of fuel traded in New York and delivered in Nebraska.
For the 57-year-old Mr. Wilson, the pricing plan proved a mixed blessing. The first year, the pump price shot up by another 20 to 25 cents, meaning he was getting a good deal. The following year the pump price dropped about a quarter a gallon, but Mr. Wilson was obliged to pay the higher price. "It hurt to have to pay for that fuel," he recalls sourly. He quit the program after that.
The finance law's imminence has prompted CPI's Mr. Brandt to warn his sales team and customers that the co-op may have to end its maximum-price fuel contracts. He's worried too that CPI might have to cut its fuel supplies if it can't hedge against price drops.
"We have to start making a game plan if they take away the ability for us to hedge that inventory," Mr. Brandt says.
The Wilsons deliver Mr. Reeson's steer to a low, cement-gray complex on the edge of Grand Island, Neb., where trucks arrive loaded with cattle, and others leave loaded with meat. Over the past year, Mr. Reeson has sold 1,125 steer to the packing plant, which is owned by JBS USA, a Greeley, Colo., unit of Brazilian-owned JBS SA.
JBS buys livestock two ways. Sometimes it pays cash for the following week's kill. Sometimes it buys further forward, agreeing in July, for instance, to a fixed price for steer delivered in December. JBS hedges on the derivatives market to make sure live cattle prices don't drop before it takes delivery.
The company also sells beef cuts forward to restaurant chains, promising delivery at set prices months ahead of time. JBS expects to have enough meat to fulfill the agreements. But if it runs short, it doesn't want to risk having to pay higher prices to buy meat to supply those restaurants.

So, it uses the derivatives market to play it safe. To do so, the company has to find a way to hedge different cuts of beef: Tenderloins might represent 1.5% of the total value of a steer. Strip loins might make up 3%. In a sense, JBS protects itself by reconstructing the steer through a derivatives trade on the Chicago Mercantile Exchange. "We try to put the carcass back together financially," says company spokesman Chandler Keys.
The company hedges electricity for its refrigerators and natural gas for its boilers. It hedges currencies to stabilize its income from overseas. It hedges fuel for its fleet of thousands of trucks.
Even executives at a big firm such as JBS haven't been able to nail down the precise impact of the legislation on their business, introducing an unaccustomed level of uncertainty into their operations. They aren't changing the way they use derivatives, yet, hoping instead that exemptions for commercial users will insulate them.
"To get food, particularly highly perishable food like meat and poultry, through to the consumer, you have to manage your risk," says Mr. Keys.

Derivatives Defined

from WSJ:

Derivatives are financial instruments whose value "derives" from something else, such as interest rates or heating-oil prices. The first derivatives were crop futures, which appeared in the U.S. at the end of the Civil War and became a standard facet of business for companies across America.

Not All Derivatives Are to Blame For the Financial Crisis

from WSJ:
Any doubt about how broadly U.S. corporations rely on fancy financial instruments vanishes with a look at who's lobbying Congress to forestall tougher regulation.

Companies from Caterpillar Inc. and Boeing Co. to 3M Co. are pushing back on proposals to regulate the over-the-counter derivatives market, where companies can make private deals to hedge against sudden moves in commodity prices or interest rates.

Many in Congress blame such instruments for exacerbating the financial crisis last fall. To fix the problem, a White House plan unveiled last month calls for more of the trades to take place on exchanges where regulators can monitor them, and requires dealers -- and ultimately companies -- to put more money aside to secure against big losses if trades turn bad.

This naturally has Wall Street in a stir, but it has also sent dozens of big manufacturers and other major corporations scurrying to Washington.

Caterpillar, which uses derivatives to offset increases in the price of copper, says new regulations may drive U.S. companies to seek financing overseas.

MillerCoors LLC, Bayer AG's U.S. unit., and Delta Air Lines are among those lobbying on derivatives, which they use to manage fluctuations in materials prices, commodities, fuel, interest rates and foreign-currency swings.

At least 42 nonfinancial companies and trade associations are lobbying Congress on derivatives, according to a Wall Street Journal analysis of lobbying disclosure forms filed through April.

That's more than triple the 14 nonfinancial companies that lobbied on derivatives in all of 2008 and zero in 2005. The figures include only companies that specifically name derivatives as a lobbying issue.

"Not all derivatives have put the financial system at risk and they should not all be treated the same," Janet Yeomans, treasurer of 3M, wrote in a letter to Sen. Mike Crapo (R., Idaho).

The companies argue the White House plan will make it more expensive to manage risks and force them to put aside cash as collateral that could otherwise be used more productively.

Treasury officials say their aim is to prevent another financial meltdown caused by hidden exposure to derivatives risk.

The issue will be fleshed out Friday as lawmakers question Treasury Secretary Timothy Geithner in a joint hearing hosted by the House Financial Services and House Agriculture committees as they grapple with crafting legislation. Some lawmakers say they hear the concerns and fear the new rules will hurt American companies, but there are others who want to push for more regulation.

Companies use derivatives to hedge risk. A company that borrows money at a variable interest rate might buy instruments to turn the borrowing into fixed-rate debt. Others use derivatives as protection against swings in currencies or the price of commodities such as food and oil.

Lobbyists say at least 90% of Fortune 500 companies use over-the-counter derivatives.

The administration's proposal calls for all "standard" derivative contracts to be cleared through a central body and traded on an exchange or equivalent electronic platform.

The clearinghouse would require daily pricing of the assets, which could require companies to post additional collateral, in the form of cash or short-term securities. Customized contracts would be permitted, but the proposal would require higher levels of capital to secure against risks.

Nonfinancial companies say it's unfair for them to be put in the same boat as Wall Street speculators, some of whom use derivatives to make bets on market movements. They also say they typically have collateral backing the risk and standardized contracts aren't necessary.

Chesapeake Energy said it had $6.3 billion in over-the-counter derivatives as of June 2008, against which it posted $11 billion in collateral, backed by letters of credit and mortgages on its gas and oil properties.

"This is how most end-users utilize this market and, as a result, help alleviate systemic risk," Chesapeake said in a letter to the Treasury Department.

Energy companies are particularly worried because the swings in oil and gas prices are so wide. Barry Russell, president of the Independent Petroleum Association of America, warns that restricting hedging would have "a devastating impact."

The National Association of Manufacturers has intensified its meetings with lawmakers, officials said, as has the Business Roundtable and U.S. Chamber of Commerce.

At a recent hearing, Sen. Crapo said he agrees regulation is needed to protect the economy against systemic risk, but "if Congress overreaches ... I believe there could be very significant negative implications on how companies manage risk."

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Jose Kernen Reveals His Stupidity

This morning on CNBC's "Squawk Box", Joe Kernen, one of the co-anchors for the show, revealed his bias and stupidity when he suggested that congress should outlaw all margin futures trading, requiring all market participants to put up all cash to buy or sell in the futures markets. This would effectively ban futures trading for anyone but huge billion-dollar corporations that are self-funded, and drying up liquidity overnight.

He thought this would drive down commodity prices. What a stupid thing to say! One of the reasons that futures trading is effective for all traders is that the many participants in the market add liquidity. His absurd idea would completely dry up all liquidity in the futures markets. That liquidity benefits all participants, big and small, in the futures markets. It is the grease that keeps the futures markets vibrant and effective. That liquidity provides accurate and constant pricing discovery, which is absent in the rest of the world's $500 trillion derivatives pool that Warren Buffett describes as "financial weapons of mass destruction". It also provides a marketing mechanism for farmers year-round. Futures are the only liquid derivatives in the world, and Joe Kernen wants to destroy the only derivatives market in the world that works!

What will happen when Congress gets the same silly idea into their heads when other people on Wall Street begin to take up the banner and lobby for the same idiotic ideas? Or what if the Fed promotes that idea? Or some other lobbyist for an interest group that tries to persuade Congress that futures traders and hedge funds are the cause of inflation?

As I said, many of the traders in the futures markets are farmers, who market their products in the futures markets and plan to make delivery of their agriculture products. They buy and sell their products through futures, often with the intent to deliver the product at the end. If they couldn't sell their products, what would they do? Dump their product at the side of the road, the way they used to do in the mid 19th century before they could get honest prices, and before the Chicago Mercatile Exchange was created to provide the mechanism to accomplish that? What would America's agriculture pros do if only big corporations could get credit, but not America's farmers? These people are the heroes of our country, keeping our families fed and allowing the rest of us to live in more urban settings. Did Joe Kernen forget that?

Mr. Kernen thinks that liquidity provided by the Fed -- and backed by taxpayer dollars -- is a good thing. He loved the Fed bail-out and engineered JP Morgan rescue of Bear Stearns two weeks ago. He likes liquidity in the mortgage-backed securities market, and thinks that is a good thing. He even talks about the idea of the Fed and the taxpayers buying all the toxic mortgage soup his friends created. He also thinks that liquidity in the stock market is a good thing. He didn't suggest eliminating margin use in the owning of equities, did he? But he has the asinine notion that eliminating liquidity in the futures market would force prices down and eliminate inflation. It wouldn't! It would simply dry up pricing accuracy for farmers and add fuel to the toxicity in the financial mess his buddies on Wall Street created. It would very likely force prices even higher as farmers reduce their yields when they can't get a fair shake.

This absurd suggestion not only reveals his gross bias for equities. It also reveals how stupid the guy is regarding the laws that govern the financial markets, and what makes them work.

Futures are the only derivatives form that most people can participate in. They are also the only derivatives market in the world that is not only liquid, but has deep liquidity without constant government intervention that disrupts the markets. In 150 years, no futures broker has ever gone belly up in the United States and left its clients holding the bag! Not once! Can Joe's Wall Street buddies say the same? How many financial crises have been created by his buddies, including the current one? Perhaps that's why the futures market works, Joe!

The whole credit crisis and mortgage melt-down has occurred because his buddies on Wall Street, for whom he has such a love affair and bias, created derivatives instruments that aren't liquid and therefore can't be traded! They can't buy or sell them, and they can't price them. They just sit there like rotting refuse on the books of companies and pension funds around the world. And now Joe Kernen cheerleads while the Fed and the taxpayer is on the hook to rescue all that toxic financial waste. No one knows what all that toxic paper is worth. These non-liquid derivatives are the cause of the entire mortgage melt-down, the plunge in the stock market, and the current recession, and yet we don't hear Joe Kernen ranting against them, do we?

Why doesn't Mr. Kernen go back to studying biology? At least that's something he understands!

Perhaps we who work in the financial markets should express our displeasure to CNBC, either by email, or by bolting to the Fox Business Network or Bloomberg. Perhaps that would teach Joe Kernen a thing or two!

Derivatives Trading and Liquidity in Financial Markets

I have been intrigued throughout my trading career with the derivatives markets. The recent subprime credit crisis, and the meltdown thereof, have always been a fascination to me. However, my fascination has been somewhat from a distance.

Derivatives and Liquidity

In the early days of trading in the Forex markets, and as an evolutionary process over the years, I have come to a few decisions regarding my own trading. I realized over time that one of the primary ingredients in effective trading is liquidity.

I can quickly look at a chart and determine by the look of it whether a market or financial instrument is liquid. Which of the two ETF charts in this posting would you rather try to trade? One had volume of 2.7 million shares daily, and the other had only 3,400 shares. The difference is not just easy to see; it is also easy to decide which to trade. Trading a very liquid instrument is a critically-important element of effective trading.

For this reason, I have been distantly fascinated to wonder why anyone would create a plethora of innovative, but illiquid trading instruments that no one truly understands, and that few people even trade. Of what value is an instrument that can not be bought, sold, or traded? It can't even be accurately or honestly priced! It may be cool, or it may be hot, but if it isn't liquid, its value and future is questionable.

Brief History of Futures Markets

The futures markets in agricultural products have been in continuous existence since the 1840's. Before that, when farmers brought their products to markets, buyers were forced to pay premium and sometimes astronomical prices during the winter months when grain products were scarce. On the other hand, during the harvest season, farmers couldn't get a fair price, and stories abound of farmers who would dump their wagon-loads of grain on the streets instead of selling them at a loss, because they couldn't get a sufficient price for their products to cover their production costs and feed their families. The futures markets benefit both producers and buyers of products by evening out the extreme and wild price fluctuations that plagued producers and consumers previously. The futures markets level out and provide stability to prices for everyone.

Over time, as more and more market players have entered the markets, liquidity in the futures markets has increased and improved. Speculative players in the futures markets have made them increasingly liquid and stable. This is a benefit to all who buy and sell futures instruments. One recent example of this phenomenon is that when the softs futures became available for electronic trading, prices became more stable and market noise decreased markedly within a few months. Chart patterns have become much more consistent.

Black-Scholes and the Elimination of Risk

On the other hand, when Black and Scholes developed the models and formulas for eliminating risk in derivatives instruments, they didn't find a formula for insuring against the risk of poor liquidity. These models have, over time, proven themselves deficient and thus, incomplete. Many derivatives outside of futures are highly illiquid. In fact, many are so unique and innovative that there is no market for them. Period. In an environment like this, an new type of risk is introduced: liquidity risk. Without liquidity, prices become increasingly unstable and markets become unreliable. This increases the risk rather than eliminates it. It is simply a new form of risk that is impossible to calculate, let alone eliminate.

Liquidity Beneficial for Traders

That is the reason why I refuse to trade any futures instrument that has open interest of less than 100,000 contracts. My mentor taught me only to trade futures contracts that had at least 10,000 contracts of open interest. However, he personally only trades futures that are much more liquid than that. I have come to the same decision on my own.

Liquidity is important to me because it brings price stability to that instrument, and it reduces market noise. (Volatility is beneficial for traders, but market noise isn't. It is our enemy.) Good liquidity, in turn, allows me to improve my trading win/loss ratio by taking trades that have a higher degree of reliability and chart accuracy. As markets become more liquid, charts patterns, and their predictive capability, also become more accurate and reliable. Bid/ask spreads become concomitantly tighter, and the cost to trade is reduced. It becomes easier and earlier to reach break-even and profitability.

That's why I've always been intrigued with the constant creation of innovative and never-before-heard-of derivatives instruments. The more new and creative they are, the less liquid they become, and the more unreliable become those markets. Liquidity risk increases exponentially with the innovative nature of the derivative instrument. I choose reliability over creativity when it comes to placing my money at risk. Only thus can I reduce that risk. Unfortunately, innovativeness is the enemy of liquidity, and thus, profits, in the world of financial derivatives.