From the December 01, 2006 issue of Futures Magazine • Subscribe!

Trade locally, think globally

The Chicago Board of Trade is considered the center for agricultural commodities trading, with benchmark contracts for soybeans, oats, rice, corn and wheat. And back in 2004, the exchange began collaborating with the Kansas City Board of Trade (KCBT), the Minneapolis Grain Exchange (MGEX) and the Winnipeg Commodities Exchange (WCE) to host their native agricultural commodities on the e-cbot electronic trading platform, consolidating access and thrusting these regional exchanges onto the line of fire for speculative trading.

The MGEX, KCBT, CBOT and WCE each offer wheat contracts on the e-cbot platform, but the contracts do not compete directly. Each contract fills a different requirement to a common pool of buyers and there are limited opportunities to substitute one wheat contract for another (see “Scouting report”).

“It provides one-stop shopping for the different varieties of wheat,” says Jeffrey C. Borchardt, president of the 150-year old KCBT. “And now with the move to side-by-side, you can access the three electronically and not only do the individual business, but you can do the spreading electronically.” In addition, the contracts have spread credits across the exchanges allowing for SPAN margining, which magnifies the appeal to funds and commercial traders.

A bigger pie

Long before the CBOT centralized electronic trading for grains and oilseeds, the 125-year old MGEX had decided to go it alone. In 2001, the exchange launched its hard red spring wheat (HRSW) contract and five new cash-settled agricultural indexes on the OM platform.

“We had the double challenge of: one, marketing new products; and two, marketing a new way to trade these products,” says Mark G. Bagan, president and CEO of the MGEX. “While we learned a lot, frankly, volume for these contracts was not what we anticipated it being.” After four years of losing money, the MGEX pulled the plug on the OM electronic trading platform and relaunched after-hours electronic trading of the MGEX flagship hard red spring wheat contract on e-cbot on Dec. 15, 2004.

Both the MGEX and the KCBT facilitated the transition by installing electronic trading stations on the trading floor, allowing floor traders to monitor and execute trades with hand-held devices, adding liquidity to electronic trading and to the pit. “It’s a situation where the pie just continues to get bigger in both venues and everyone flourishes as a result,” Borchardt says, adding that 10% to 15% of the KCBT volume is now electronic.

The WCE made the switch more abruptly. On Friday, Dec. 18, 2004, WCE closed its trading floor and the following Monday opened as a fully electronic exchange, and it also added overnight trading in August, 2006. While the WCE is seeing increased volume and open interest, Will E. Hill, senior vice president of the exchange, says electronic trading is not a panacea. “As technology centers itself and becomes homogenous, you don’t get an advantage from technology, and that goes for all exchanges. You’re then forced to compete for liquidity with larger exchanges.”

From locally to global

With the electronic trading technology in place, the regional exchanges are now being forced to compete with larger exchanges for volume, according to Hill. So the key to continued success is leveraging the existing regional advantages, such as existing products, liquidity pools and storage and delivery points in global competition. “For example, we are getting a lot of uptick in our canola market from the bio-diesel industry in Europe.”

The WCE is the world’s pricing mechanism for canola, also known as rape seed, and because of its high oil content and “healthy oil” status, canola is now used for food and is the feed stock for bio-diesel production in the same way that sugar and corn are feed stocks for ethanol production.

Hill says while the alternative fuels markets organize themselves from a risk management standpoint, the immediate opportunity is in the alternative fuels feed-stock futures, and the WCE is uniquely positioned to capitalize on that emerging demand.

“There is this huge ethanol industry south of the border [in the United States] and huge bio-diesel industry in Europe; and Canada is becoming the center of that feed stock,” he says.

With drought wrecking the Australian wheat crop this year and the U.S. Department of Agriculture projecting global end stocks at their lowest level in 25 years, the KCBT and the MGEX are finding themselves increasingly in the global spotlight.

The KCBT hard red winter wheat (HRWW) futures represents 50% of the wheat grown in North America, and for the eleventh time in 13 years the KCBT has set an annual trading volume record on the contract. As of late September, more than 18.45 billion bushels had traded this year.

In all of 2005, the exchange traded 18.41 billion bushels. Another product that the KCBT offers is clearing services. The KCBT clears and guarantees all of its own products and provides back office services to the WCE. “That’s where we are looking for any opportunity to expand the value of our clearing medallion,” Borchardt says. “We have the horsepower and the capacity to do that, and so it adds value to our membership.”

The unique opportunities at the MGEX are the cash settled agricultural indexes, Bagan says. “These are actually national averages of what farmers or producers are being paid at elevators around the nation.” For example, the national corn contract averages what more than 2,000 grain elevators are paying farmers.

“What’s unique about that is, from a farmer-producer perspective, it mirrors the actual prices that are being paid in this country.”

Bagan argues that pricing mechanism of the cash settled contracts is easier to understand and that they have better correlation with the cash market prices. And the MGEX HRSW contract continues to perform very well, open interest for HRSW is up 40% at the MGEX. “We are running about 16% ahead of last year. We are growing that contract and, as I said, that’s the same contract we’ve been trading for more than a century here,” Bagan says.

Bagan says another reason for the growth at the MGEX is that floor traders have embraced the change to electronic trading and realized that, with the addition of the new contracts, nothing has been taken away from them.

“The floor community didn’t look at this as messing with anything they had going. These products had never been trade in a pit environment before. If they wanted to trade it electronically, they had that opportunity,” Bagan says.

Cross over appeal

Volume on the regional exchanges has historically been driven by commercial hedgers, but with the technological advances, including the single platform to trade on the three exchanges, the introduction of cash settled ag-index contracts and SPAN margining, the regional exchanges are actively courting the index community and hedge funds.

“The challenge is getting in front of the investment community or the index community and describing why allocating a portion of their portfolio to the MGEX hard red spring wheat contract is a worthwhile endeavor to them,” Bagan says.

And being able to electronically trade the spread relationships between the wheat contracts and explain the distinctions between the three wheat contracts is helping them to increase asset allocation.

“It’s a sellers market for liquidity right now. Because there is so much money that wants to come into different products, it’s more about creating products and having product available,” Hill says, adding that hedge fund volume, which used to represent just 20% of the volume on the exchange, has increased to about 33%. “It started with oil and the metals and the softs and now it is coming into the grains,” he says.

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