The contract must be structured to promote convergence.
The rice futures contract is not a particularly efficient hedging tool, so four years ago the USA Rice Federation formed the Rice Futures Contract Working Group to study the issue and look for ways to improve the contract’s performance.
Our contract struggles with low volume and episodes of wild basis swings (the difference between the cash price and the contract price) that end up reducing confidence in the contract to function properly. Reduced confidence leads to low volume. Low volume leads to wild basis swings and poor price discovery. A vicious cycle and a struggling market are the result.
In order to improve our contract and build confidence in it as a hedging tool we knew we had to address these wild basis swings (that sometimes were as pronounced as 20 percent) and structure the contract to promote convergence. Convergence is when the nearby futures price and the cash price at the delivery point become equal. The core integrity of a futures contract is convergence. And Warehousemen Regular for Delivery, registered with the Chicago Board of Trade (CBOT), are the key to convergence.
If the Warehouseman can buy cash rice at a substantial discount to the futures (low basis), then sell the nearby futures and deliver the rice into his own facility, he makes a profit. This process drives the futures prices down and the cash prices up, and the market converges.
The down side for the Warehouseman is that when he delivers, he gives up control of some of his bin space, and filling up and emptying that space is the most profitable part of his business. The Warehouseman has to balance the opportunity of taking delivery with the ability to service his customers, both farmers and end users.
However, if we can increase the amount of space available for the Warehouseman to take delivery, you increase the likelihood that he will want to capture the wide basis margin when it occurs and drive the market back toward convergence.
Enter The Shipping Certificate
Shipping Certificates, as the delivery instrument, can add this extra storage space by allowing for off-site storage, and create transportation efficiencies, thus encouraging transactions that drive convergence.
Convergence is when the nearby futures price and the cash price at the delivery point become equal. The core integrity of a futures contract is convergence.
Shipping Certificates also reduce back office paperwork since all associated charges are calculated electronically, as opposed to warehouse receipts that are done manually. It’s worth noting that Shipping Certificates are the delivery instrument for all other grains traded on the CBOT – for corn and soybeans since 2000, and for wheat since 2009. These changes corresponded with a dramatic increase in volume in those contracts.
In February, the Working Group recommended to the USA Rice Federation Board of Directors that the delivery instrument for the rice futures contract be changed from a warehouse receipt to a Shipping Certificate collateralized by a warehouse receipt. The Board approved the recommendation, and it has been sent on to the Chicago Mercantile Exchange.
However, when the Working Group met in April, it discovered the CME rules dictate that if a warehouse receipt is used to collateralize a Shipping Certificate (rather than a Letter of Credit), the warehouse receipt must be located at a delivery point. The Working Group and the CME will have to address this issue if the change is to be meaningful.
Change is never easy, but this is a group effort. It is a testament to the rice industry that we were able to come together under the banner of the Federation to address such an important issue.
John Owen is a rice grower from Rayville, La. Economic research provided by Dr. Fred Seamon, Milo Hamilton and Evan Spencer.