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From the MPC Newsletter
October 24, 2008

Some Background About the CME and How It Works
By John Kaczor, Editor of the MPC Newsletter

Not a week passes without reference to what has happened to Cheddar cheese and butter prices (and occasionally, nonfat dry milk prices) on the CME. It’s important to follow those prices because they are the most current indication of changes in cheese and butter prices – two of the major three products that are used in milk price formulas in California and federal orders, and (we are told) by plants in unregulated areas that compete with plants that are regulated.

Disclaimer. CME Group and its predecessor, the Chicago Mercantile Exchange, stand behind the market it provides for Spot sales of Cheddar cheese, butter, and nonfat dry milk. They believe it represents a fair and open market for informed parties to buy or sell those products through bids and offers made in a public place under agreed upon rules. When criticized about the “thin” trading that takes place (few traders making few trades representing a small percentage of all sales), CME responds, quite correctly, by saying the CME Spot market offers a public way to determine current values for the products that are traded, and has not been represented as being useful or appropriate for setting milk prices. The idea to use the Spot markets for purposes of setting milk prices originated with milk producers, manufacturers, and distributors, and is supported by producers, manufacturers, and distributors.

Spot trading of butter in Chicago began in 1898. Spot trading of Cheddar cheese in Chicago began in 1997. (The National Cheese Exchange which had operated in Green Bay, Wisconsin, was closed down shortly before cheese trading began in Chicago.)

Some of the questions that have been asked include:

bulletWho are the people who make the trades that change the prices?
bulletHow do the prices change?
bulletWhere does this happen?
bulletWhat are the rules regarding payment and delivery of products that are traded?
bulletHow are the rules enforced?
bulletHow do buyers and sellers in different parts of the country get together?
bulletCan anyone find out who are the buyers and sellers and bidders?
bulletWho makes sure that the rules are followed and that inappropriate things do not happen?

The Spot market for the three dairy products mentioned above takes place in a designated place on the floor of the Exchange. The market is open Monday through Friday; each product is given about five to fifteen minutes to transact business. Bids to buy and offers to sell may be posted on a board prior to each session, and additional bids and offers may be made during the session The bids and offers are handled exclusively by accredited commodity brokers on behalf of their clients, who can be anyone who has product to sell or who wishes to buy. If you want to buy or sell butter, cheese, or nonfat dry milk on the Spot market, you must contact a broker who has a license to trade.

The identity of bidders is not made public. When a bid to buy is made, the potential buyer does not know who and where the seller might be; likewise for potential sellers. The buyer and the seller must file a report with the CME Market Regulation Department by 3:00 p.m. the day of the trade to disclose their identity. (Although it is not public information, there are some reports that participants generally know which brokers represent which clients.) In cases where an offer or a bid moves a price, the identity of the broker who made the offer or bid is recorded.

A sale is a sale. The seller agrees to follow the buyer’s instructions on when to ship the product. The buyer pays the freight cost, but can receive an allowance from the seller to cover part of that cost. Payment for butter is made the first business day after the sale; payment for cheese is made within three days of the sale. Payment is made through charges and credits through registered accounts.

Butter is sold f.o.b. Chicago. The buyer receives a predetermined allowance from the seller depending on how far the point of delivery is from Chicago. The maximum allowance is $.055 per lb for deliveries beyond 1,600 miles from Chicago. Cheese is sold f.o.b. Green Bay, Wisconsin. The allowance the buyer receives from the seller depends on the distance between buyer and seller, and how far the seller is from Green Bay. (Simple examples: if the buyer and seller are located in central California, no allowance is given; if the seller is located in Wisconsin and the buyer is located in central California, no allowance is given; if the seller is located further away from Green Bay than from the buyer, the buyer receives an allowance for the freight from the seller’s location.) In addition to allowances for delivery, other allowances include how long and where and how butter has been stored, and the moisture content of cheese, and others.

The Exchange has established rules for product grades, packaging requirements, and sizes of transactions. A “carlot” of butter (40,000-43,000 lbs) is the specified transaction size for butter; a “carload” of cheese (40,000-44,000 lbs) is the specified transaction size for cheese. Prices change (up or down) when an offer to sell or a bid to buy is accepted at a price that is different from the existing price. Prices also change (down) when an offer to sell at a price lower than the existing price is not covered, or (up) when a bid to buy at a price higher than the existing price is not accepted. Failure to follow through on a bid or offer is subject to fines and reprimands, and could lead to suspension of trading privileges. Disputes between parties are resolved by the CME.

Concerns about manipulation of prices in a “thin” market are valid, but the CME and industry participants generally agree that there is little evidence of manipulation, and if it occurs it likely cannot be sustained for very long because of the number of parties who represent all aspects of the dairy industry can and do observe the daily activity. While sales on the Spot market represent a very small percentage of all sales, the description of the CME Spot markets for dairy product as thin is disputed because almost all butter and cheese cash and contract sales use the Spot prices as a reference point, and there are few who propose discontinuing its use. The point made is that it is thin in fact but is very broad in practice. Even so, there are some who say it is disconcerting to note that a single transaction on the Spot market, whether or not it involves a trade, does affect the value for virtually all cheese that is sold in the U.S.

The CME has in the past four years improved its oversight of the dairy Spot market. Among other controls, a “market surveillance analyst” is assigned to the Spot market to review transactions and consider possible connections between Spot trades and positions held on the futures market, and an investigator looks for signs of price manipulation and may interview brokers, buyers, and sellers about particular actions. The end.

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