If you remember my open letter that I wrote upon shutting down my commodity brokerage firm in November of ARSH 2011, i ended it with the words of David from Psalm 117: 23, “This is The Lord’s doing: and it is wonderful in our eyes.”
At the time, I spoke those words through gritted teeth. It stung to quit “early”. I had just turned 35. In my mind, quitting, being “beaten” and failure are admittedly intertwined.
Now? Oh, goodness. If I had a tambourine, I’d go dancing down the street. Thank you, thank you, thank you Jesus for extracting me out of that mess when You did.
I quit primarily because of Jon Corzine’s brazen theft of $1.6 billion of segregated customer funds, with ZERO consequence and, in fact, the clear cooperation of the CME Group, the CFTC, SEC, National Futures Association (a straight-up, textbook racketeering organization if ever there was one), judiciary, Department of Justice and United States Congress. MFGlobal will go down in history as a watershed event that publicly blew the lid off of the true state of lawless oligarchy in the former United States – even though only a handful of people ever really heard about it, and even fewer understood it.
Yes, I did also perceive, and spoke and wrote at length both here, in my Economics video presentation, and in various interviews and podcasts, about the futures markets descent into total fraud and eventual irrelevance because of High Frequency Trading – that is to say, computer algorithms taking over the market, and making them basically impossible to trade. This all began at roughly the same time that the Chicago Mercantile Exchange changed from being a non-profit entity to a for-profit entity. Once that shift was made, the CME management no longer gave a crap about protecting market integrity, and thus protecting the market participants themselves, but rather in generating as much income as possible. To that end, two things happened: first, the CME stopped performing its primary function of acting as the universal guarantor and backstop. When Corzine swept the MFGlobal customer accounts in order to pay his proprietary margin call on his hyper-leveraged in-house repo and credit default swap trades with JP Morgan and Goldman Sachs, and the CME did not immediately step in and guarantee the $1.6 billion in customer accounts despite the fact that their emergency slush fund at the time topped $8 billion – leaving the MF Global customers not only the victims of theft with zero legal recourse, but refusing to allow then to EXIT THEIR TRADES, thus exposing them to incomprehensible risk – that was when we knew that the CME was truly finished, and that the whole Godforsaken mess would implode upon itself eventually.
Second, when the CME transitioned to for-profit, their drive became to generate as much income from “transaction fees” as possible. Enter the High Frequency Trading paradigm. The CME saw the immense volume of trade that HFT would and does generate, and saw that their “future” was not in you know, actual, legitimate hedging and price discovery of physical commodities, but rather in turning the CME into a giant computer gaming platform.
It also bears mentioning at this point that the CME opened up and began actively soliciting and incentivizing with reduced margin requirement rates Central Banks, as in the Federal Reserve Bank of the U.S., the European Central Bank, the Bank of Japan, etc., yes, central banks that have the ability to PRINT THEIR OWN MONEY, to trade the markets. The CME knew as well as you and I know that allowing an entity that can literally print its own money to meet margin calls effectively destroys the concept of price convergence and price discovery of physical commodities. AND the incomprensibly sick notion that it is okay for Central Banks to trade the derivatives markets on THEIR OWN SOVEREIGN DEBT PAPER. But they did not and do not care. All they care about is the massive income generated by the fees paid on every transaction by these enormous, high-volume “customers”. And the actual hedgers and producers of physical commodities who are simply looking for risk management tolls can all GO. TO. HELL.
Well, well. Now we have reportage over at Zerohedge that my old markets – the Live Cattle futures markets – are basically now a completely untradable, unusable monstrosity, and all of the remaining “human” traders and hedgers are throwing up their hands and leaving, because the HFT influence over the markets has caused MASSIVE volatility – volatility so severe that the intra-day margin calls, of which there could be several in both directions per day, are potentially ruinous to any sort of legitimate client.
I wrote about exactly this all the way back in ARSH 2011. I warned that the deathknell of these markets would be the DELINKAGE of the cash (physical) market from the futures markets. I wrote my explanation in the context of metals, but it is now happening with cattle.
And yes, this feeds EXACTLY into my cattle marketing DVD set, which is all about discerning not merely price, but VALUE of physical commodities, and value is a completely different animal from price. Once VALUE is determined, one can then see which classes of a given physical commodity (in this case, cattle of all sizes and types) are OVERVALUED and which are UNDERVALUED, and the profit spreads between them. The price becomes almost irrelevant, and is really only a function of UNITS, not informative in-and-of-itself for discerning which cattle should be SOLD and which cattle should be BOUGHT within the spectrum. Further, volatility becomes not only manageable, but sometimes beneficial as it causes unskilled marketers who operate on emotion to inject profit opportunity into the physical market because of their bad, emotionally-driven decisions. So long as the SELL and the BUY are executed at the same time, the overall price level in that moment is irrelevant, and volatility becomes moot – provided, of course, that one is NOT leveraged, or only very, very minimally leveraged. Leverage re-exposes even the soundest marketer to risk. Leverage is dumb, no matter how low the interest rate. Again, this paragraph is talking about PHYSICAL commodities. The futures markets are FINISHED, and if you trade them, you are A FOOL, and will deserve whatever you get.
Here is a reprint of the piece I wrote about this delinkage of markets as they die from back in ARSH 2011. It is presented in terms of metals, but the concept is the same for all physical commodities and their forward delivery (futures) markets.
Originally penned and posted on December 15, ARSH 2011.
When Markets Disintegrate: Cash-Futures Delinkage
Finally, a very simplistic explanation of how the cash commodity markets are soon going to decouple from the futures markets. This is a little complex, but stay with me. I think this is important to understand because none of us who have lived our whole lives in the U.S. have ever seen a market disintegrate.
The threat (or promise) of delivery upon expiration is what keeps the futures markets tethered to the cash markets. Up until now, if an unreasonably wide spread between the futures price and the underlying physical commodity market got too out of whack, a process called “arbitrage” would kick in. Arbitrage is when a party simultaneously buys and sells on two separate but related markets in order to capture an inefficient spread between those two markets.
I’m going to use precious metals as my example commodity because there are a lot of metals guys reading this, and because the metals markets will be the big tell in term of when decoupling and thus total futures market disintegration is upon us. But these examples apply to all of the physical commodities.
Let’s say that the physical silver market is trading far lower than the silver futures price. This is what is called a WEAK BASIS. The BASIS is the relationship between the cash market and the futures market and is very simply defined as (CASH minus FUTURES). If cash silver can be bought at $25.00 per ounce and the futures are at $30.00 per ounce, the cash is $5.00 under the futures. When cash is under the futures, this is called a WEAK basis.
Up until now, what would a metals trader do? In very simple terms, he would buy the cash silver at $25.00 per ounce and then simultaneously sell the futures at $30.00. Because he has short-sold the futures, he could hold the contract to expiry and then deliver the $25.00 cash silver he bought to make good on the contract and receive his $30.00 price. So his simple net profit would be $5.00 per ounce. As many traders saw this spread and simultaneously executed this same strategy of buying the cash and selling the futures, what effect would this have? Right. It would cause the cash-futures spread to move back in toward convergence by pushing the futures price down (lots of sellers) and propping the cash market up (lots of buyers).
Now the opposite scenario: a STRONG basis. Let’s say cash silver is trading at $32.00 and the futures are trading at $28.00. A trader might take physical silver that he has in inventory and sell it in the cash market, and then immediately take those proceeds and buy back and equal number of ounces in the futures market and take delivery. Since the same number of ounces in the futures market cost $4.00 per ounce LESS, he would end up with the same number of ounces in his inventory PLUS $4.00 per ounce in CASH in his pocket. If he and many other traders saw this condition and they all sold cash silver and bought the futures, this would, again, converge the spread between the cash market and the futures market.
The lynchpin that is holding this dynamic together and keeping the futures markets tied to the underlying cash market is the fact that the futures contracts are deliverable, and a trader can either deliver or take delivery of actual physical silver via his futures position.
Are we seeing a problem yet? The futures markets have lost their viability and trustworthiness because of the MF collapse and theft. At some point in the not-too-distant future, people everywhere are going to realize that the delivery mechanism is not reliable. Heck, just holding cash and/or positions in a futures account is no longer reliable. If the futures market itself is not reliable, traders will no longer attempt to arbitrage these basis spreads because the risk to the trader that the rug will be pulled out from underneath them is simply too great.
And in the metals markets, the delivery process itself is . . . um . . . shall we say, easily corrupted? When you ”take delivery” of physical metals, it doesn’t get sent to your house. All you get is a certificate saying that X number of ounces are being held in a certified vault somewhere with your name on them. After the MF collapse, that sounds like a joke, right? A CERTIFICATE with my NAME ON IT? Yeah. That really is how it works.
When the arbitrageurs finally lose all confidence in the markets, the cash market will decouple from the futures because no one will be willing to take the risk of having their money, positions and/or physical metals stolen/confiscated. If no arbitrageurs are willing to trade these spreads – no matter how wide they may become – and thus there is no force causing the cash and futures to converge, we will see the basis spreads become extremely wide. As people flee the futures markets, the futures prices will drop, while the cash markets hold steady or even diverge and actually rise as all of the former paper players realize that physicals are the only remaining game to be played.
Watch for this. Watch for the gold and silver futures to sell off as people walk away from paper while the online cash dealers, seeing that market demand for their physical inventory is robust, begin to ignore the futures prices and hold their prices steady or even raise them. When you see this basis decoupling and absence of arbitrage, lo, the end is nigh.