Friday, September 21, 2012

The Golden Age of Commodities Market Manipulation: Corners, Storage and Squeezes

A Corner Solution: Commodity Futures, Default
Fines, and Unintended Consequences
Wojtek Sikorzewski
We analyze one specific form of market manipulation - corners (or squeezes) in some commodity futures markets. In the analysis we focus on the role of institutional factors such as the storage capacity at the delivery point and the severity of fines imposed on defaulting shorts. We analyze the influence of these factors on the likelihood that a corner-style manipulation might occur. A reduction in storage capacity or an increase in the amount of fines imposed on defaulting shorts increases the probability of the occurrence....

1 Few historical examples
The nineteenth century could be described as the ”golden age” of commodity futures manipulators. The exchanges’ internal rules were very permissive (e.g. no position limits) and the directors boards were very unlikely to take important measures to curb any nascent corner. Furthermore, the regulatory constraints were virtually non-existent. [the first binding act of U.S. Congress -the Commodity Exchange Act - was enacted in 1922]. Thus, during this period we can observe the interactions of purely economic factors with no regulatory intervention. In this section we describe three1 cases of attempted manipulation reported by W.G.Ferris [1] and J.W.Markham [3]. Our intent is to provide some factual evidence of corners (two successful and one failure) in which institutional factors played an important role.

1.1 Benjamin P. Hutchinson in 1866

Benjamin Hutchinson led one of the first attempts to manipulate the Chicago wheat markets. His goal was to squeeze the August 1866 wheat contract. Benefitting from weak harvest forecasts he built up a considerable long position in the cash grain and in futures contracts in May and June 1866. The average purchase cost of wheat was reported to be around 88 cents per bushel 2. In August the price rose steadily following the reports of weak harvests in Illinois, Iowa and other states tributary to Chicago. On August the 4th the wheat contract was quoted at $ 0.90 - 0.92.

On August the 18th Hutchison’s demands for delivery raised the wheat price to $1.85- $1.87 causing the shorts huge losses. This corner and the other squeezes that followed Hutchinson’s example prompted the directors of the CBOT to proclaim such activities illegal. They gave the first definition of a corner determining it as the practice ”of making contracts for the purchase of a commodity, and then taking measure to render it impossible for the seller to fill his contract, for the purpose of extorting money from him”. They deemed such transactions improper and fraudulent, and declared that any member of the CBOT who engaged in this type of transaction should be expelled from the board. These declarations, however, had no effect on actions undertaken by some traders in the following years. Some of these attempted corners did not succeed and led
their initiators to bankruptcy and ruin.

1.2 John Lyon in 1872

On the 6th of October 1871 a spectacular fire, known as ”the Great Fire”, destroyed a big part of the city of Chicago. Six out of seventeen regular grain elevators burned down which considerably reduced the storage capacity in Chicago from around 8 million bushels to 5.5 million. An important wheat merchant, John Lyon, felt that it was a good moment to launch a corner on wheat. He formed a coalition with Hugh Maher, another grain dealer and P.J. Diamond, a CBOT broker. In spring 1872 the group started buying wheat (physical and futures). The price of wheat kept rising during spring and the August contract sold at the beginning of July for between $1.16 and $1.18 a bushel. It reached $1.35 by the end of the month. This price rise caused a massive expansion of wheat arrivals in Chicago. They averaged 14,000 bu. per day at the beginning of July and then steadily rose to 27,000 bu. a day during the first week of August. During this week, on the 5th of August, one more elevator, ”the Iowa Elevator”, was destroyed by a fire, further reducing Chicago’s storage capacity (by 300,000 bushels).

Furthermore, bad weather reports reinforced rumors that the new crop would mature too late for delivery against August contracts. This added up to the buying pressure causing the contracts to reach $1.50 by the 10th and $1.61 by the 15th. This was the peak of the operation.

The news about such high prices in Chicago made farmers greatly accelerate the harvest. W.C Ferris [1] reports lanterns carried via railroads to enable farmers to harvest the grain at night. On their way back to Chicago the trains transported ever greater amounts of wheat. In the second week of August the daily arrivals averaged 75,000 bushel and on 19th they reached the unexpected and astonishing level of 172,000 bushels. For the rest of August,estimated daily arrivals were between 175,000 and 200,000 bushels.
At the same, time the normal commercial channels were reversed. Usually, wheat from Chicago was shipped via Buffalo to the West Coast cities. Because of shipping costs the wheat price in Buffalo was generally higher than in Chicago, but in August 1872 the Chicago price was high enough to make shippers transport wheat from Buffalo back to Chicago to sell it to Lyon. In fact Lyon had to keep the price high, and therefore had to keep buying the grain coming to Chicago in order to make his corner succeed. But the amount of wheat coming to Chicago greatly exceeded his anticipations and his financial resources. He was then obliged to raise more money with local banks. Chicago bankers were unwilling to lend him additional resources. Furthermore new elevators, constructed after the Great Fire started operating. It was estimated that the storage capacity was raised to 10 million bushels, a level 2 million bushels higher than before the 1871 fire. This further stretched the financial resources of the Lyon’s group.

Lyon kept buying the grain till the afternoon of Monday, August the 19th, but he stopped when he learned of the banks’ refusal to support him. The price of wheat immediately fell 25 cents a bushel. On August the 20th Lyon announced the break down of the corner which caused an additional decrease of 17 cents per bushel
This collapse ruined J.Lyon, who was unable to redeem his debts. P.J. Diamond destroyed his books and disappeared. Other corners, however, did not end with the ruin of their initiators. The corner launched by Benjamin Hutchinson in 1888 is considered one of the most successful corners ever attempted....MORE (pp 5 of 14 page PDF)