Manipulation cases take place in commodity markets. Therefore, to understand manipulation requires a basic understanding of what a commodity market is. Thus, this chapter will start by explaining a commodity market from the point of view of buyers, sellers, exchange officials, and traders.
A. Selling to the Commodity Market
You are a successful corn farmer in Iowa. Surprised? Look around you. It is March, and you are standing in an extremely large field covered by snow. You have a comfortable warm home, and some nice barns and other buildings. While you are cold now, you know (or at least are fairly confident) that in a few weeks it will warm up, the snow will disappear, your field will dry, and you will be planting corn for harvest in September and/or October.
Since you are successful you are no doubt good at growing corn. Farming, however, is about more than growing. Farming is also about managing financial risks, and you are good at that as well. In particular, you are planning to plant corn soon. Planting corn costs money, and while you are financially well off (on paper), most of your wealth is actually invested in the land, and not that easy to get in the form of cash. Thus, you are likely to go into the nearest decent sized town, and borrow money from your favorite banker.
Despite what one might infer from the 1890s and 1930s populist literature, the banker is your friend. You may have known him or her all your adult life. S/he agrees to loan you the money you need for planting in exchange for you paying the money back when your crop is harvested, plus a market rate of interest.
Your friend the banker is now (just like last year) your partner. If you do not have the money to pay back the loan, his/her life is going to get rather difficult. Certainly, the bank could foreclose on your land and get some (though unlikely all) of its money back. But the bank really does not want to do this. Foreclosure is a great way to make enemies, which the bank does not need. Further, the bank does not really know what to do with your land.
At this point, both you and your partner, the bank, are interested in reducing your risk. One risk you have is that, while you can observe the price of corn on the “spot” market for delivery today, you really have little idea on what the price of corn will be when you are ready to deliver it in the Fall. It could be high (good for you!) or it could be low (bad for you and your banker). Thus, you have “price risk” that you and your banker will want to reduce.1
It is for the problems like this that the Chicago Mercantile Exchange has a commodity market for the type of corn you grow. Therefore, you call your financial agent (you have one of those as well) and put in instructions to sell your expected corn crop. You might order your agent to sell one million bushels of corn for October delivery. In about an hour (or less) your agent tells you that your October corn has been sold, say at a price of $3.50 per bushel. You have entered into what is called a “futures” contract, because you have promised to deliver a good in the future. Since you now owe the exchange the corn, you are said to be “short” in corn. By contract, your corn must be delivered to warehouses in Chicago (or perhaps other specified delivery points) on or near a specified date in October.
Now the commodity exchange owes you one million bushels times $3.50 per bushel equals $3.5 million in October (minus relevant financial fees, of course). You owe the exchange one million bushels in October. Of course, the exchange is not planning on what it is going to do with your bushels. For, when you sold the exchange your bushels, the exchange simultaneously sold those bushels to someone else, who now owes the exchange money. You do not know whom your bushels were sold to, and you do not care. (Unless, perhaps, you do not think that exchange is selling the bushels to parties of good credit.) Trading is thus anonymous.
Trading with the commodity exchange did more than solve your liquidity problem. The amount of corn you plant in the spring is not fixed. In terms of a standard introductory economic textbook, you have diminishing returns. What that means is that the larger your (expected) production, the higher the marginal cost of that production, that is, the incremental cost of the last bushel of corn you will produce. Since you understand basic economic theory quite well (whether or not you had to sit through that boring five hundred-person lecture class at the university), you will do your best to choose the amount of corn to grow such that the marginal cost of producing that corn equals the price you received from the Chicago exchange.
The price of corn also sends you a signal about what type of investments you should make. You are considering purchasing some land close to your current farm. The land might grow corn, or it might grow soybeans. Before you consider whether you should buy the land, you (and again, the bank loaning you most of the needed money) will try to figure out what this land is worth. The value of this land is, of course, directly related to the price of corn. While you do not know what the price of corn will be in the future, the best estimate of that is likely to be contained in the prices for the future delivery of corn.
As stated above, you are now legally committed to deliver your corn to the Chicago exchange. While you could in fact deliver that corn, doing so might be fairly difficult and complicated.2 In any event, there are plenty of buyers for your product who will take delivery from your grain silo, or that of your cooperative. There is no need to ship corn to Chicago exchange.
Thus, when you draw close to harvest, and you have a good idea of how much corn you will be producing, you agree to sell your corn to one or more of these buyers in exchange for a price no doubt influenced by the price at the Chicago exchange. At this point, you might think you have a problem. You have sold your crop of corn twice.
There is, however, no real problem. Your obligation to the exchange is what is termed “fungible.” This means that, from the point of view of the exchange, you can eliminate your obligation to the exchange by buying one million bushels of corn. To do this you now “go long” one million bushels of corn at the exchange, perhaps in terms of a futures contract that will expire in a few days.
Now you might think you are one million bushels long and one million bushels short. But since these contracts are fungible, one short bushel is simply the opposite of one long bushel. In other terms, corn is a “commodity.” One unit of corn is just as good as another unit of corn. Thus, your long bushels and your short bushels completely cancel each other out. Congratulations! You have now “flattened” your position. You do not owe the exchange anything, and the exchange does not owe you anything.
At this point, you have sold your harvest in March for a price, sold it again in the beginning of October, and then bought it back in the beginning of October. The two prices of October, however, are likely to be close to each other. Thus, when you sold your corn in March, you, in effect, “locked in” your price for October. This action makes both you and your banker happy. You have eliminated your financial risk. The net effect of your actions is described in Table 1.
Table 1: Your Actions as a Farmer.
There is, however, one assumption in this story that has not been examined yet. The story assumes that when you want to flatten your short position at the beginning of October, there is someone else who wants to flatten their long position. If there is not, you might have to buy corn from warehouses in Chicago to meet your obligations to the exchange. As we will see later on, this could be very costly to you.
B. Buying from the Exchange
You are no longer standing in a field in Iowa, breathing fresh air, and wondering where your toes went. Instead, you are in a nice heated office in a medium sized city. You are a purchaser of corn for a major food processor. Since most of the corn that your firm wants is harvested in the Fall, you plan to buy your corn during that period. Your firm can store the corn for later use.3
While you know that you will be buying corn in the Fall, you do not know what the price will be for your firm. This poses apparent financial risks for your firm. I say “apparent” because while you took a course in risk management while gaining your business degree at the university, the course probably did not bother to explain to you why a firm like yours would want to engage in risk management. You do not think your firm is like your former self the farmer, living from harvest to harvest.
There are perhaps two relevant theories why your firm is engaged in risk management. First, there is always the chance that your firm could go bankrupt. Bankruptcy involves a great deal of legal fees,4 and a large number of restraints on your firm. Perhaps worse, the senior managers of the firm, the people you report to, are likely to be replaced should bankruptcy occur. They would not like this, so they instruct you to take steps to decrease the possibility that this might happen. To reduce the threat of bankruptcy to your firm from corn prices that might skyrocket, you are ordered to get a fixed price for the Fall delivery of corn.
Yet, truth be told, bankruptcy for your firm seems unlikely. There might be another reason why your firm wants you to fix a price for its future purchase of corn. Perhaps that reason is that your firm is always worried about having enough cash on hand to take advantage of what business opportunities might arise. Your firm is aggressive about looking for new investments. These opportunities will require cash if your firm wants to take advantage of them. Certainly, there are other ways for your firm to get cash. It could float a bond, or get a loan from a bank. These actions, however, will take time, and allow outsiders to further scrutinize the firm. Having a “war chest” on hand makes the firm more flexible. If the price of corn does soar and the firm has not already fixed in a price, the amount in that war chest could decline.
Thus, you make many purchases of corn from the exchange in Chicago. You are now “long” with respect to the exchange. In one of these, you buy one million bushels of corn from the exchange for delivery in October. While it may turn out that the (notional) bushels you bought were from your previous farming self, you do not know this, and you do not care. What you do care about is that the bushels you have bought are fungible, and you can sell them back to the exchange before you are required to take delivery of them.
Of course, you are not that eager to actually take delivery of the corn in Chicago. Instead, however, you send your buyers out across the American Midwest to buy corn at good prices from farmers and farmer cooperatives near or immediately after the time of harvest. Your firm has developed specialized methods of picking up this corn and taking it to your factories and storage facilities.
The price your firm pays for corn that it takes delivery on will be closely related to the price of corn at the exchange. Once your firm has bought physical corn in the countryside, it is now time to close out your position. You sell your futures contract at the exchange (again, you do not know and do not care who buys your contracts) and flatten your position.
You have now bought the corn you needed twice, and sold it once. The price you bought the corn for the second time, however, is very close to the price that you sold the corn. Thus, the price that you paid for the corn futures in March is the final cost of the corn to your firm. By buying corn on the exchange, corn that you did not intend to take delivery on, you fixed in the price your firm will pay for corn.
There is, however, one underlying assumption here. You assume that when you want to flatten your long position, there will be someone, most likely a “short,” willing to buy it.
