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By Theopolis Waters and Tom Polansek
CHICAGO (Reuters) - CME Group Inc <CME.O>, the largest U.S. futures market operator, said on Tuesday that it will step up surveillance of its lean hog futures next week to prevent price manipulation under a pricing formula the exchange adopted to cope with the shut down of the U.S. government.
The closer look from the exchange-operator's market regulation department will guard against potential price manipulation during an adjusted settlement procedure for the contracts, said Dave Lehman, CME's managing director of commodity research and product development.
If the government's shutdown extends to October 15-the day after the CME October lean hog contract expires-the exchange operator will base the final settlement on a "volume weighted average" of trades made the previous two trading days-Friday, October 11 and Monday, October 14. Data from the U.S. Department of Agriculture, normally used to calculate final settlement, would not be available.
CME had no choice but to revamp its settlement calculation after the USDA pulled the plug on its daily, weekly and monthly reports, including those containing livestock and meat prices. The reports are the industry's benchmarks and have been the basis of U.S. cash contracts between hog processors and producers.
Using a volume weighted average of futures prices over two trading days is the best way to reflect USDA data in the absence of the government reports, Lehman told Reuters. Spreading the calculation period over two days reduces the risk of manipulation, he said.
"There's extra scrutiny being put on this expiration," Lehman said. "Our market regulation department can see who's in the market, who holds positions, who's trading, and they can monitor that and take action if they need to, if it looks like prices are being distorted."
Some traders worry that CME's revised methodology could create an opportunity for potential manipulation because more volume at a specific price on those days will have a greater influence in calculating the final settlement price. Any trader holding an open position at expiration will be paid or charged based on the final settlement figure.
"I fail to see how CME's solution ties to cash prices when I know there is little or no authoritative cash price information available right now," R.J. O'Brien hog futures trader Tom Cawthorne said. "It brings up more questions than answers."
"The plan by CME is confusing and opens the door to the possibility that a group of individuals could manipulate the market by taking it higher or lower, depending on their positions," Cawthorne added.
EXPIRATION CLOCK TICKING
With a few days left until expiration, 18,566 October hog futures contracts remained open as of the start of trading on Tuesday. That equates to some 3.7 million pigs.
University of Missouri livestock economist Ron Plain said the exchange's alternative settlement will be a step down from its traditional practice, but may be the best option available given the circumstances.
"CME's got this dilemma. The contract expires early next week and they've got to have some sort of mechanism for settling," Plain said.
The country's leading meat packers, including Smithfield Foods <000895.SZ>, Tyson Foods <TSN.N> and Cargill Inc <CARG.UL> also had to adopt new methods when the USDA data they used for purchase contracts with hog producers became unavailable. They came up with alternative pricing formulas to get them through until the government resumes its daily market reports.
Steve Meyer, president of Iowa-based Paragon Economics and consultant to the National Pork Board, said it is not easy to gauge how the various revamped pricing strategies will affect producers.
"You're pricing hogs with something that is estimating the price of hogs and nobody knows the price of hogs," he said. "I'm not sure whether there is a better alternative right now."
"You'd like to know where the CME lean hog index is before you bet on where it might be," he added.
(Editing by Bob Burgdorfer)