The True History and Utility of Futures

If farmers want to move ahead of today's global grain trading environment, one of the first things to do is to better understand the history of where it all began. 

The Chicago Board of Trade (CBOT) was launched way back in 1848 by a group of 25 Chicago businessmen. It stemmed from shortcomings in the system at the time of strictly cash market activity between farmers and buyers, where a glut of grain offered at harvest inevitably meant rock bottom prices.

At the time, grain buyers had no way of knowing what the price might be in the future, or if there would still even be any old crop grain offered for sale in the waning months of the year prior to the next harvest. There was already plenty of production risk in farming courtesy of Mother Nature.

Balancing Crop Marketing Risk with Reward

The founders of the CBOT reasoned that buyers and sellers ought to be able to commit for forward transactions at mutually agreed-upon prices, quantities, grades and delivery terms to reduce the additional element of price risk and uncertainty in their business.

But a problem quickly developed when trading of such contracts was limited to bonafide producers and bonafide users. There was constant imbalance between the amount of grain being offered and the amount needed on any given day. Result: Unacceptable day-to-day volatility in prices for both buyers and sellers.

That’s when CBOT founders decided to add trading volume and market liquidity, which allowed speculation by investors with no ability or intent to grow, or deliver to sell futures contracts, so long as they showed the financial wherewithal to accept the risk of prices rising.

The Addition of Speculative Investors

In a similar manner, investors with no ability or intent to accept delivery could buy futures, provided they showed the financial wherewithal to accept the risk of falling prices. 

It was controversial to be sure.

Even back then there were fierce critics of speculation. Nonetheless, opening futures markets to speculative investors added the vital trade volume and liquidity needed to assure that whether buying or selling, hedgers could get in and out of positions easily on any given day.

It had the added benefit of becoming a fair and valuable price discovery tool for both buyers and sellers. And, it helped to encourage production and ration usage in times of tight supply and to slow production and encourage more usage in times of surplus. There remain echoes of the early critics from cynics who still see speculation as a scourge and futures markets little more than casinos.

Marketing Today's Crop

But the echoes are growing more dim as the majority of today’s farmers see futures and options as the valuable risk management tools they were meant to be. The vast majority of today’s farmers understand full well that they are “long” on any portion of a growing or stored crop that is not priced or hedged (sold) in futures. They benefit from rising prices but are hurt by falling prices – exactly the same as an urban investor who is long “on paper.”

In fact, in some cases, the farmer who is long a growing or stored crop faces more risk than the urban speculator because he or she is exposed to cash basis risk as well. Basis is the term given to the difference between a local cash bid, which varies widely across the country on any given day, to a specific futures contract which is the same for everybody on any given day.

Variation in basis from locale to locale is a function of supply or demand imbalance at the local level, the time of year and variation in the cost of delivering grain to a recognized delivery point for satisfying a short position in futures.

 

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The views expressed in this article are the author's alone and not those of Farmer's Business Network, Inc., its affiliates or members.