February 29, 2000

To:

The Commission

From:

The Division of Economic Analysis

Subject:

Applications of FutureCom for Designation as a Contract Market in Live Cattle Futures and Futures Option Contracts.

Recommendation:

That the Commission designate FutureCom as a contract market in live cattle futures contracts and options on that futures contract and approve proposed rules 7.01 through 7.05 for the futures contract and 8.01 through 8.04 with respect to the option contract.

Concurring:

Division of Trading and Markets

Office of the General Counsel

Processing Information

Submitted Under: Regular Review Procedures

Responsible DEA Staff

Official Receipt Date: 01/17/1997

John Bird

418-5274

Review Period Stayed: YES

Fred Linse

418-5273

 

Rick Shilts

418-5275

Requests for Comment

Federal Register Publication

Comments Received

Government Agency Comments

62 FR 4730, 01/31/97

62 FR 62566, 11/24/97

63 FR 1959, 01/13/98

35 independent comments were received (see discussion in Appendix A).

Staff discussions with USDA personnel included below.

 

Introduction

The proposed futures contract will be traded on FutureCom, a new futures and options exchange. The proposed contracts will be traded electronically via the Internet. This memorandum addresses the conformity of the proposed contracts with the requirements of the Commodity Exchange Act as well as the Commission’s Regulations and policies, including Guideline No. 1. The Division of Trading and Markets has prepared a separate memorandum to the Commission concerning its recommendations regarding approval of the Exchange’s proposed rules of governance and operations.

The Exchange submitted its applications for designation in live cattle futures and option contracts on January 17, 1997. The statutory one-year review period has been stayed three times, so that the one-year review period now ends on May 8, 2000.1

Cash Market Overview

The proposed futures contract will be cash settled based on USDA-reported cash prices for sales of live steers and heifers intended for slaughter. These prices reflect transactions between feedlot operators and packers involving cattle that are commonly referred to as "fed" or "slaughter" cattle.

The primary cattle feeding states are Colorado, Kansas, Nebraska, Oklahoma and Texas. Data published by the U.S. Department of Agriculture (USDA) indicates that these states accounted for more than 65 percent of all cattle in U.S. feedlots on January 1, 1999 and in excess of 83 percent of all U.S. fed cattle marketed from feedlots having an annual capacity of 1,000 or more cattle during 1998. These states also accounted for about 66 percent of total number of cattle commercially slaughtered in the U.S during 1998. In recent years, between 640,000 and 715,000 cattle have been slaughtered per week on average in the U.S.

The Slaughter Cattle Production Process

The production of beef cattle consists of three growth stages. The first stage is the seven to ten month cow-calf stage, which begins with the birth of the calf and ends when the calf’s owner (cow-calf operator) weans it from the mother cow. The second stage of production commonly is the stocker cattle stage - the period when weaned calves purchased from cow-calf operators consume forage from pastureland to increase muscle mass rather than fat. Stocker cattle commonly are sold to feedlot operators after they have attained a weight of about 700 to 800 pounds. At this point, the cattle enter the third stage of production, the feeder cattle stage, in which the animals are fattened for slaughter. In this stage, the cattle are fed concentrated diets of corn and other feed grains until they attain slaughter weight (about 1,100 to 1,300 pounds).

Upon reaching slaughter weight, fed cattle are sold to packers for slaughter, frequently through packer buyers, who buy for individual packers, or order buyers who purchase for more than one packer. While most fed cattle are produced and marketed by independently owned and operated feedlot firms, some fed cattle are produced by packers. Packer-owned cattle may be fed on contract at the facilities of independently owned feedlot operators or in feedlot facilities owned and operated by packers. Fed cattle generally are slaughtered near the feedlots where they are grown to market weight. Fed cattle typically are sold to packing plants located near the feedlots in order to minimize transportation costs as well as weight loss and potential injuries to the cattle. Typically, these cattle are between 1½ and 2 years old.

Market Structure

The primary cash market participants are feedlot operators and cattle packing firms. Most cash market transactions are executed on a spot basis, calling for delivery of the fed cattle to packers within several days. Some fed cattle are sold under forward contracts or other marketing arrangements.

USDA data indicate that there are more than 2,000 feedlots with a capacity of at least 1,000 head of cattle, and over 100,000 feedlots with a capacity of less than 1,000 head of cattle operating in the United States. The latest available information indicates that the 25 largest cattle feeding firms operated 99 feedlots in 1996, with a combined capacity of about four million head. These 25 firms are estimated to have accounted for about 37 percent of all fed cattle marketed in the U.S. in 1995.

According to data reported by USDA’s Packers and Stockyards Administration, there are approximately 800 federally inspected2 cattle slaughter plants in the U.S. These plants slaughtered a total of over 34.6 million head in 1998. Fourteen plants, each of which slaughters more than one million head per year, accounted for approximately 50 percent of all cattle slaughtered in the U.S. The latest available information from USDA indicates that the largest four cattle packing firms accounted for about 80 percent of all steers and heifers slaughtered at federally inspected plants in the U.S during 1998. These four firms operated 25 plants in 1997.

Slaughter cattle are generally sold in truckload units of about 40,000 pounds. A typical truckload of slaughter cattle contains about 33 to 35 animals, each weighing over 1,100 pounds. Slaughter cattle generally are sold by the hundredweight (cwt.). Transaction prices are in terms of dollars, cents and fractions of a cent per hundredweight.

Existing Futures Markets and Available Cash Price Information

Currently, live cattle futures contracts are actively traded on the Chicago Mercantile Exchange and the MidAmerica Commodity Exchange. Unlike the proposed futures contract, these existing futures contracts call for the physical delivery of live cattle.

Price information regarding sales of slaughter cattle are published by the Agricultural Marketing Service of the USDA (USDA-AMS). The 5 Area Daily Weighted Average Report, the price series to be used to calculate the cash settlement price for the proposed futures contract, is published by USDA-AMS.

Terms and Conditions of the Proposed Futures Contract

Futures Term Exchange Proposal Comment/Analysis
Commodity Characteristics Live slaughter steers and heifers (typically, cattle of 1.5 to 2 years of age and 1,100 to 1,300 pounds in weight that are intended for immediate slaughter) included in the 5 Area Daily Weighted Average Report published by USDA-AMS. Acceptable for hedging cash positions. The standards used in producing the 5 Area Daily Weighted Average Report reflect the majority of slaughter cattle traded in the cash market.
Settlement Procedure Cash settled using variation margin procedures. The cash settlement price will be calculated by the Exchange based on the weighted average price per pound and the number of live slaughter steers and heifers reported sold in the USDA-AMS 5 Area Daily Weighted Average Report for the 5- day period ending on the last trading day. Acceptable. Meets the requirements of Guideline No. 1 (see below).
Contract Size 40,000 pounds of live slaughter steers and heifers. Acceptable. There are no delivery concerns given the cash settlement provision. The trading unit represents about one truckload of live slaughter cattle.
Trading Months February, April, June, August, October, and December. Any months are acceptable given cash settlement provision and on-going hedging needs.
Trading Hours (Central Time) Trading hours: 9:00 a.m. to 1:00 p.m. Any hours are acceptable.
Last Trading Day Business day immediately preceding the last ten business days of the contract month. Any day is acceptable. The 5 Area Daily Weighted Average Report is published each business day of the month.
Pricing Basis and Minimum Tick In dollars and cents per pound, in increments of $0.0005 per pound ($20.00 per contract). Acceptable. The minimum tick is smaller than the minimum cash market price fluctuation. Prices are reported in the 5 Area Daily Weighted Average Report in dollars and cents per hundredweight (cents and hundredths of a cent per pound).
Daily Price Limit $1.50 per hundredweight ($600 per contract), expandable to $3.00 per hundredweight. No limit during last 5 trading days in an expiring future. Given customary daily cash price changes, the price limit is not overly restrictive and, therefore, is acceptable.
Speculative Position Limits 1,000 contracts in any non-spot individual contract month. Consistent with Regulation 150.5 and the Commission’s policy on position limits for new agricultural contracts. The absence of an all months combined limit is acceptable due to low correlation of prices between months.
  500 contracts in the expiring contract in the 10-day period preceding contract expiration (this includes the cash settlement period). Appropriate to reduce incentives to attempt to manipulate the cash settlement price. In this respect, the proposed spot month limit is equivalent to about one-sixth of the minimum volume of cattle (100,000 head) that will be used to calculate the cash settlement price.
Reportable Position Level 25 contracts. Acceptable. The proposed reportable position level equals minimum level set by the Commission for futures contracts.

 

Description of the Futures Cash Settlement Price

Introduction

As indicated above, the cash settlement price for the proposed contract will be the weighted average price3 per pound of live slaughter-weight steers and heifers during the last five trading days of the expiring contract month as calculated by FutureCom from daily transaction data reported by USDA-AMS in its 5 Area Daily Weighted Average Report. The proposed rules provide that, in the event that the total number of cattle reported in the 5 Area Daily Weighted Average Reports for the last five days of trading is less than 100,000, the cash settlement calculation period will be expanded, as necessary, to assure that the calculated cash settlement price is based on a weighted average price representing at least 100,000 cattle.

The 5 Area Daily Weighted Average Report incorporates the prices and quantities associated with direct sales of slaughter cattle between feedlots and packers, for immediate delivery, in the states/regions of Nebraska, Iowa-Southern Minnesota, Kansas, Colorado and Texas-Oklahoma. Prices for cattle to be delivered more than seven days in the future are reported separately, while prices and quantities for cattle sold through auction sales as well as prices/quantities reported for packer-owned cattle are excluded from the report. Only Select through Choice grade steer and heifer data is used in calculating weighted average prices. Specific types of cattle, such as Holsteins, Corrienties, bulls, and heiferettes, are excluded from the weighted average price calculation. Price data are gathered and reported on the basis of dollars and cents per hundredweight. Weights used in the USDA-AMS reports may be actual measured weights, or estimates of cattle weights provided by feedlot managers, packer/buyers or order buyers.

The USDA-AMS Price Reporting System

The USDA-AMS has been publishing the 5 Area Daily Weighted Average Report that will underlie the proposed cash settlement price since 1990. In this regard, USDA-AMS price reporters gather the price, quantity and weight data for cattle transactions through interviews of cash market participants. Data are collected on the basis of actual sales reported by cash market participants, but are reported as a range and weighted average for specified weight and grade categories. The 5 Area Daily Weighted Average Report and the corresponding reports for individual states included in the 5 Area Daily Weighted Average Report are released by USDA-AMS on a daily basis. The USDA-AMS price reporters contact all major market participants on a daily basis and also receive daily reports from many smaller participants regarding slaughter cattle transactions.

The USDA-AMS price reporters are trained, full-time employees of USDA. Price reporters are not permitted to trade agricultural futures or option contracts.

Data Retention

USDA-AMS, as a matter of policy, does not maintain data, other than that contained in the published reports. The data pertaining to each report are maintained in files on laptop computers. These data files are overwritten and thereby destroyed with the entry of new data for a new report. Official USDA policy is to destroy any other data or information maintained by price reporters as soon as it is clear that the final report is accurate, generally not later than the morning of the business day following publication. USDA-AMS publishes the 5 Area Daily Weighted Average Report as well as the reports for each of the underlying states electronically on the "USDA Wire," i.e., the data are published on the Internet and may be accessed through the USDA's Website.

Commission Guideline No. 1 Requirements for Cash Settlement Price Series.

As noted in the below table, the Division believes that the proposed cash settlement price satisfies the requirements of Section B(3) of Guideline No. 1 regarding cash settlement provisions for futures contracts. The cash settlement price will accurately reflect the underlying cash market and will not be readily susceptible to price manipulation. In addition, the cash price series upon which the cash settlement price will be based is reliable, acceptable, timely, and publicly available.

The Division also notes that the CME currently uses daily cash market transaction data reported by the USDA-AMS to calculate cash settlement prices for its feeder cattle and stocker cattle futures contracts. These data are similar to data reported by USDA-AMS in the 5 Area Daily Weighted Average Report. Those futures contracts have traded without problems.

Guideline 1 Requirements for Cash Settlement Prices

Requirement Comment/Analysis
Not readily susceptible to manipulation. The calculated cash settlement price and the price series that the cash settlement price that the calculation will be based upon are not readily susceptible to manipulation for the following reasons:
  • The underlying cash price data are collected by an independent third party, USDA-AMS. USDA-AMS specializes in collecting and reporting agricultural market data, including cash market price and transaction information.
  • The USDA-AMS-reported cash price and volume data are based on arms-length sales transactions between unrelated entities. The USDA-AMS price reporters routinely verify transaction information received from buyers and sellers. In addition, USDA-AMS price reporters do not report data that they believe is in error or that is not representative of the cash market.
  • The cash settlement price series will represent weighted averages based on sales of a significant amount of cattle over an extended period - a minimum of 100,000 heifers and steers over at least 5 days. Thus, the prices reported for one or a few transactions that are significantly above or below prevailing prices will have no material effect on the reported average price.
  • The settlement price calculations will incorporate data for a minimum of 5 days. Thus, any attempted manipulation will require actions over an extended period that will be visible to USDA-AMS, the CFTC and FutureCom in their ongoing surveillance activities.
  • USDA-AMS price reporters are full-time employees who are trained, unbiased observers of the cattle markets. Price reporters are not permitted to trade cattle futures contracts.
  • The 500-contract spot-month speculative position limit will discourage attempts to manipulate the cash settlement price by making it difficult to profit from a manipulation of reported cash market prices. The cash settlement price calculation normally will be based on slaughter cattle sales equivalent to at least 2,750 futures contracts.4
Reflects the underlying cash market. The cash market transaction data to be used in calculating the cash settlement price represent essentially the entire live slaughter cattle market in the five areas from which data is gathered which, in turn, represents a majority of the slaughter cattle produced in the U.S. Cash market sources indicate that the price data reported by USDA-AMS are widely believed to accurately reflect actual conditions in each of the individual markets for which reports are generated.
Reliable indicator of cash market values and acceptable for hedging. The underlying cash price series (published each business day) reflects day-to-day changes in live slaughter cattle prices and the number of animals priced. In addition, the prices reported in the 5 Area Daily Weighted Average Report are used to price some boxed beef as well as being used as an indicator of the current market. Therefore, the proposed cash settlement price will be a reliable indicator of cash market values and be acceptable for hedging.
Publicly available and disseminated on a timely basis. The data that will be used to calculate the cash settlement price are released to the public by USDA-AMS in its 5 Area Daily Weighted Average Report each day. The report is distributed electronically (via the internet and Autofax) from USDA-AMS. Printed copies are also available from the USDA-AMS.

 

Terms and Conditions of the Proposed Futures Option Contract

Option Term Exchange Proposal Comment/Analysis
Underlying Futures Contract FutureCom live cattle futures contract. Standard for options on futures.
Exercise Style American style. Acceptable.
Speculative Position Limits (Checklist Item 1) Combined with positions in underlying futures contract, at the futures contract’s levels set forth above. Same as underlying future speculative limit rules. Consistent with Guideline No. 1 standard and acceptable.
Aggregation Rule (Checklist Item 2) Same as Rule 150. Consistent with Guideline No. 1 standard and acceptable.
Reporting Level (Checklist Item 3) 25 contracts. Consistent with Guideline No. 1 standard and acceptable.
Trading Months February, April, June, August, October and December within the next 24 months, or any other month specified by FutureCom and approved by the CFTC. Acceptable, same initial months as underlying future.
Strike Prices (Checklist Item 4) Strike prices initially listed at the opening price of underlying future rounded to nearest $2 per hundredweight and at $2 per hundredweight intervals in a range $10 above and below that price, with additions as necessary to ensure that all strike prices are listed within the $10 range above and below the current transaction, bid and/or offer price. Specified and automatic, and therefore acceptable.
Last Trading Day and Expiration Date

(Checklist Item 5)

Same as underlying future, that is, the business day immediately preceding the 10th to last business day of the contract month. Meets Guideline No. 1 cash-settled futures option standard (must expire on or before last trading day of future).
Automatic Exercise at Expiration In-the-money options, absent instructions to the contrary. Acceptable.
Minimum Tick (Checklist Item 6) $0.0005 per pound ($20.00 per contract). Consistent with Guideline No. 1 standard (equal to futures contract’s minimum tick).
Premium Fluctuation Limits (Checklist Item 7) None. Consistent with Guideline No. 1 standard (equal to or greater than price limit for future).

 

Federal Register Comments

FutureCom’s proposed rules were published for comment on January 31, 1997 (62 FR 4730) and November 24, 1997 (62 FR 62566) for 30 days. On January 13, 1998 the second comment period was extended to January 26, 1998 (63 FR 1959). The comment files (there are two) contain a total of 43 documents, of which eight were received from FutureCom (W. H. O’Brien) or memorialize meetings with FutureCom.

Entities that responded to the Federal Register notices included cattle feedlot operators, other cattle firms, a cattle industry association, a telecommunication/computer software firm, two legislators, and four commodity exchanges. All cattle industry commenters and the telecommunications/computer software firm supported the proposed contract. The commodity exchanges raised a number of issues regarding FutureCom’s proposed electronic trading system and other proposed aspects of FutureCom’s exchange functions and a few in regard to the proposed futures contract. The concerns of the commodity exchanges regarding proposed contract terms are described and addressed below.

COMMENT:

RESPONSE:

The cash settlement price is vulnerable to manipulation due to the tendency of most cash market sellers to refrain from making weekly selling decisions until a few sellers decide to sell (most slaughter cattle are sold on one or two days of the week). As a result, a small number of transactions by one or several sellers can strongly influence the cash settlement price, thereby increasing the vulnerability of the cash settlement price to manipulation. The proposed 500-contract spot-month speculative position limit will be ineffective in deterring such manipulation attempts.

As discussed above, the proposed cash settlement price meets all Guideline No. 1 requirements. The tendency noted by the commenter does not undermine the cash settlement price. The purchasing and selling strategies of cash market participants do not change the fact that the proposed cash settlement price will be based on actual cash market transactions for at least 100,000 head over five business days with oversight of the price reporting process by USDA-AMS. While the sale of a few cattle may stimulate overall sales of cattle each week, the prices reported for all of these sales reflect bona fide cash market transactions for a substantial quantity of cattle. Moreover, it is unlikely that cash market participants can predict accurately the full impact on market prices of the cattle sales that occur on any given day. In particular, no seller can be certain that other sellers will be prompted to sell a significant number of their cattle in response to sales by that seller on any given day. Also, even if significant sales of cattle do occur on the same day on which a seller initiates cattle sales, that seller can not be certain which direction daily prices may change in response to such sales. Prices may increase or decrease unpredictably on those days when the majority of slaughter cattle are sold. Finally, the proposed 500-contract spot month position limit will significantly limit the profit a potential manipulator could derive from an attempted manipulation of the cash settlement price.

The daily settlement price, which normally would be based on transactions occurring during the last three minutes of trading, may not adequately reflect closing contract values in cases where there are no transactions in the last three minutes of trading. This is because the proposed rules provide that the daily settlement price then would be based on actual transactions occurring earlier in the trading day, or in cases where there are no transaction prices during a trading day, on the opening price for that day which could, in turn, be based on the five-day-weighted average price for live cattle (based on prices reported by USDA-AMS) for the preceding business day. It was indicated that, in these instances, basing daily settlement prices on bids or offers during the final minutes of trading would more accurately reflect closing contract values. It was also contended that, basing the settlement price on the preceding trading day’s five-day weighted average price for cattle could result in excessive and totally unnecessary margin calls to one side of the market and an undeserved profit to the other side of the market when the five-day weighted average price is significantly different from the equilibrium price of a deferred contract month.

The proposed daily settlement price rules are acceptable, since they provide an objective means of establishing the daily settlement price. There is no requirement of the Act or in the Commission’s regulations and policies that bids and offers be used in calculating the daily settlement price. Moreover, the proposal appears reasonable since the daily settlement price will be based on transaction prices during the final three minutes of trading and provide for the use of transaction prices over periods of time longer than the last three minutes of trading, or the trading day's opening price if there are no trades on that day, only if there are no transactions at or near the close of trading. In regard to the concern about the impact on daily margin requirements of the proposed use of the five-day weighted average price as the settlement price, the Act does not contain requirements regarding the setting of daily margins by futures exchanges, or any restrictions on the procedures for establishing settlement prices in relation to the potential impact such procedures may have on daily margin requirements. Moreover, the five-day weighted average price will be used as the opening price only as the final default if no trading had taken place in the contract that will otherwise establish an opening price.

Conclusions

Proposed Futures Contract: The Division of Economic Analysis has completed its review of FutureCom's proposed live cattle futures contract. The Division believes that the proposed futures contract meets the requirements of the Commodity Exchange Act (Act), the Commission's Guideline No. 1, and Commission Regulation 1.61 concerning speculative position limits. Also, the Division, based on its analysis, is of the opinion that the proposed futures contract reasonably can be expected to be used for hedging on more than an occasional basis. Finally, the Division is of the opinion that the proposed futures contract does not appear to be readily susceptible to price manipulation or other distortion and is otherwise consistent with Section 5(7) of the Act which requires that designation of a contract market not be contrary to the public interest.

Proposed Option Contract: The Division is of the opinion that the terms and conditions of the proposed option contract meet all of the standards for designation found in the Act and regulations thereunder, including Part 33. In particular, the Division notes that the proposed option complies with standards for the seven specified criteria the Commission adopted in Guideline No. 1.

Attachments:

  • Proposed rules for the subject futures and option contracts
  • The Exchange’s application and other background materials are not included as part of this document but are available to the Commission upon request. The proposed orders of designation and letter to the Exchange are included with the memorandum of the Division of Trading and Markets.

1 The running of the statutory one-year review period initially was stopped in a letter to FutureCom from the Division of Trading and Markets dated April 15, 1997, with the review period recommencing on May 13, 1997 with the Exchange’s submission of supplemental materials. The review period was stopped again in a letter to FutureCom from the Division of Trading and Markets dated June 20, 1997, with the running of the statutory review period recommencing on November 18, 1997 after the Commission received additional supplemental submissions from the Exchange. Finally, the statutory review period was stopped in a letter to FutureCom from the Division of Trading and Markets dated March 24, 1998, before recommencing on January 19, 2000, with the Exchange’s submission of materials regarding the adequacy of the FutureCom’s electronic trading system.

2 These 800 Federally inspected plants account for about 95% of all cattle slaughtered in the U.S. All slaughter plants that ship meat in interstate commerce must be federally inspected.

3 The weighting factor to be used in calculating the cash settlement price will be the number of head in each weight/grade category sold on a live basis each day.

4 In reviewing the proposed cash settlement price, the Division also has considered whether the relatively high levels of concentration in the ownership of slaughter capacity or the prevailing degree of concentration in the ownership and/or control of slaughter cattle could make the cash settlement price vulnerable to manipulation. In this regard, while there may be concern that a single large entity could arbitrarily influence the cash settlement price by providing to USDA cash market transaction data that is either false or does not adequately reflect average cash market values observed during the cash settlement period, the Division believes that the considerations noted above will act to prevent or discourage cash market participants from attempting to manipulate the cash settlement price by such actions. In addition, the Division notes that the Commission has approved cash settlement provisions for futures contracts in which the underlying cash market exhibits substantial concentration. In particular, the Commission approved cash settlement provisions for the CME’s boneless beef futures contracts which are based on prices reported by USDA-AMS for the boneless beef cash market, a market that has levels of concentration among both sellers (beef packers) and buyers (fast food restaurants, etc.) that appear comparable to concentration levels observed in the slaughter cattle cash market.