Tuesday, May 11, 2010

Free DP?  No thanks...

I have always considered free delayed (DP) pricing programs to be a masterstroke of psychological grain buying by offering an irresistible answer to a usually minor problem: move your grain out of your bins, get that job and risk out of the way and we'll hold it for free!

It is very popular in my area, even though we all know it can depress the bids, because the merchandisers already have the grain, making the need to bid up for grain when needed less urgent. Still, you get to have your grain and move it too - what could go wrong?

But the larger reason is the farmer (seller) becomes an unsecured creditor.  Not really a problem, perhaps for the multi-national buyers many of us deal with, of course.

Unless...
Quick refresher: A derivative end-user is someone -- usually a company -- who uses a derivative hedge against real risks. United Airlines hedging against a sudden spike in the price of oil, for instance. And these folks have been working very, very hard to exempt themselves from the regulations around derivatives.
But reading this piece from the perspective of a derivative end-user is a reminder of at least two reasons to be very careful with those exemptions. First, a lot of large corporations use derivatives to juice profits through, well, trading derivatives. They're not hedging risks so much as running an internal hedge fund. Cargill, for instance, is known for doing this. And if they suddenly have free rein over the unregulated derivatives market, their hedge fund business will get bigger, and riskier. That's not an incentive we necessarily want in the system. It's one thing to have to bail out an investment bank that got into risky trading. It's a whole other level of absurdity to bail out a hamburger producer. [More]
I about fell over when reading about possible derivatives regulations and came across this mention of my #1 customer. I'm sure these folks assume they have this trading under strict control, but that's pretty much what all the trading desks thought right before the excrement hit the revolving blade. I think the temptation to try fancy quantative tricks is irresistible, once you are tossing large numbers of options around routinely.

I'm not suggesting Cargill should or shouldn't be dabbling in these arcane arts, but since we now know virtually nobody in the industry or academia truly understands these markets, I think the prudent choice is to assume no market participant is "too big to fail". Or more to Ezra's point above, whether a "hamburger" producer would get the same backup from the US Treasury as a financial giant.

My customers can trade what and where they like, but not with my money. Plenty of other farmers will lend them grain/money. But for my farm, free DP may be even riskier than I thought.

4 comments:

Anonymous said...

John,

Unsecured credit and counterparty risk goes beyond deferred pricing for farmers. Bankruptcy courts also placed bola’s around the legs of producers who had forward price contracts with ethanol plants. The courts would not let the contract holder deliver grain or release them from the contract until after the date for the contract arrived. Meanwhile prices were plummeting and all you could do was stand on the side line and watch. In the end we sold our $6.20 contracted corn for $3.60 had prices appreciated during the same time the producer would have delivered and they would have sold the corn for a profit maximizing the return to the bankruptcy court and owners of the ethanol plant. For those with strong working capital or a bank that is committed, futures contracts appear the only way to mitigate a higher percentage of counterparty risk.

John Phipps said...

anon:

I agree - and am sorry for your experience. My larger point is I'm not taking any chances with business partners who dabble in derivatives. Period. No criticism or suggestions of impropriety, just a recognition that I don't understand if that activity could come back to bite me, so that kitchen looks hot enough to stay out of.

rick said...

Basis-Fix contracts and Hedge-to-Arrive contracts are also examples of derivatives. The marketing guru of Iowa State University is in love with derivative contracts such as Average price contracts and accumulators. I'm wondering if you will choose to not to work with companies that offer those tools as well?

John Phipps said...

rick:

I didn't mean to give that impression. I would do business with them, I wouldn't give them grain on free dp.

BTW, have you noticed what basis is doing now that guys have taken a look in their bins?