High Frequency Pinstriped Pirates: The Continuing Challenge of Price Discovery

Lehman450      When is a price not a price?  Is there a difference between volume and liquidity?  Whatever happened to the “Pinstriped Pirates” in the grain markets?  How many sheep do I have to sell today and does the price of sheep make any sense?  Add high frequency trading into the mix and you get a myriad of opinions of what true price discovery is.  I just want to sell my corn for $6, so sue me.

For those of us who farm in southwestern Ontario, these questions must just seem so far out there.  In my area we have being growing grains for many years priced off the Chicago market.  Sure, we debate the prices all the time but we have a pretty good idea on how the price of grain is formed.  It is imperfect, far more imperfect than our American friends, but at least we understand where it came from.  That is not always the case across North American farm country.  In fact, there’s a lot of misunderstanding and surely there are also farmers that accuse the market of being corrupt.  The question is, what does that really mean and how should market prices be derived?

Let me give you a couple Canadian examples of the problems with agricultural price arbitrage.  This past week on twitter I was told by a Western Canadian grain merchandiser that wheat was being moved in Western Canada for $4 a bushel.  That is $2-$3 less a bushel that it is in Ontario and parts of United States.  When he told me that, I said it was legalized theft.  Let me emphasize, I said legalized.  It was simply arbitrage at work, one specific commodity we hold dear, being traded to a place where it had some value, a low value at that.

This past winter I spoke on the grains in New Brunswick and in Québec.  Where I visited in New Brunswick there is very low acreages compared to the corn belt and very few end-users.  So the price of any agricultural commodity was based on the nearest big end-user, in this case in Québec.  Transportation charges were sacrosanct.  However, the price of grain was not always apparent.  At the same time in Québec there is a very defined export market for grain with its proximity to saltwater.  Needless to say, there’s not a lot of transparency as a dynamic livestock market has a high degree of regulation and secrecy on the buying side.  There is really no published list of agricultural prices across the province.

So I show up in both places and start talking about price transparency and discovery at its very basic levels.  Of course in the back of my mind, secrecy with regard to the arbitrage of agricultural prices is insane from the sellers perspective.  However, there are buyers on the other side of that desk and if they can take advantage of the situation it is what it is.

So when I saw Canadian Brad Katsuyama being featured this past week on the CBS show 60 Minutes, I took pause.  He is the lead figure in Michael Lewis’s book “Flash Boys” which talks about the nuances of high frequency trading.  Just Google his name and flash boys to see the interview.   In the book they talk about how the stock market is rigged as high-frequency traders have changed the market forever.  In fact, Canadian Brad Katsuyama was cheered on the trading floor after his interview with CNBC.  The point he was making among others was that the price the market was generating was not always fair to market participants.  Its become institutionalized to the extent that some market players were part of the problem.

It reminds me of a time 25 years ago when farmers would call me and talk about the “Pinstriped Pirates” at Chicago.  Of course, there was always very colorful language about how they were fixing the prices for grains.  It reminded me also of the time 30 years ago when I was working with an agricultural economist friend of mine in Australia.  He was talking about a sheep market where the prices were making sense.  I asked him about the volume, and he said it was fine and he couldn’t quite figure it out.  Needless to say, using these examples there are reasons that the price of corn is currently trading around the $5 futures level.  Let’s just say it’s not particularly straightforward sometimes how that is generated.

That is called price discovery.  In my 28 years writing this column, I’ve always maintained that in Canada we get that wrong.  When I see wheat trading for $4 cash in Western Canada, sometimes I think we haven’t improved that an inch.  Sure, in southwestern Ontario we understand the market much better than we used to.  However, in many parts of Canada, it still like pounding stones together.  The idea from Katsuyama and Lewis that there is an even higher high frequency fix to price discovery just makes the water so much murkier.

For me as a farmer I actually think this is not so bad.  The “Pinstriped Pirates” of yesteryear got beat down by the funds and high-frequency traders of today.  It’s provided me as a farmer with futures trading liquidity, which I like.  It might be phantom liquidity, but at the end of the day what does it matter?  Just keep in mind, not everything, even with our agricultural prices is what it seems.