Spot Cheese Market: Market Oversight Has Increased, but Concerns Remain about Potential Manipulation
Published: 2007-06-21T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Chicago Mercantile Exchange (CME) is home to the spot cheddar cheese market, which impacts the prices of virtually all cheese traded in the United States, producer milk prices, and milk futures contracts. The spot cheese market, formerly the National Cheese Exchange (NCE) in Wisconsin, has been and continues to be the subject of concerns about price manipulation. GAO was asked to examine (1) the market's structure and ongoing concerns about price manipulation; (2) market oversight and efforts to address potential manipulation; and (3) how the market impacts federal milk pricing. In response, GAO compared the markets at NCE and CME, analyzed trading data, collected information about the Commodity Futures Trading Commission's (CFTC) oversight, and met with industry participants, academics, and agency officials.
section_title: What GAO Found
paragraphs: Because the CMEspot cheese market remains a market in which few daily trades occur and a small number of traders account for the majority of trades, questions exist about this market's susceptibility to potential price manipulation. The structure and operations of the CME spot cheese market are comparable to NCE's, including trading rules, products traded, and market participants. However, there are differences, including daily trading at CME versus once-a-week trading at NCE. CFTC and CME provide oversight of the CME spot cheese market that did not occur on NCE. Both engage in activities that may detect and deter potential price manipulation at this market. CFTC, as part of its responsibility for regulation of commodity futures markets, monitors cash markets, including the spot cheese market, and can act on indications of manipulative activity. In addition, CME conducts daily surveillance and regularly reviews trading data and market trends. According to CFTC and CME officials, they have both made efforts to address allegations of the potential for price manipulation by examining the activities of participants in the spot cheese market. As of June 2007, none of these reviews have led to an instance of CFTC taking legal action against a market participant. CME's spot cheese market impacts federal minimum milk pricing through the NASS survey of cheddar cheese prices, which as shown below are highly correlated to the CME cheese prices. CME spot cheese prices are used to set long-term contracts, which are then captured by the NASS survey of cheese prices--a significant commodity component in USDA's minimum milk pricing formulas. According to USDA, the agency uses the survey, in part, because it captures more transactions than occur at the CME spot cheese market. However, in addition to largely capturing CME price data, it introduces a 1- to 2-week time lag between when data are reported by NASS and when certain transactions captured in the survey occur. Moreover the survey is not currently audited to ensure the accuracy of the information. These factors may contribute to milk prices paid by dairy market participants that are either not completely accurate or not current.

section_title: Letter
paragraphs: For almost a decade, the Chicago Mercantile Exchange (CME) has been  home to a spot cheese market, which impacts the prices of virtually all  cheese traded in the United States as well as producer milk prices and  milk futures contracts. This spot cheese market moved to CME in 1997  amid allegations of price manipulation on the National Cheese Exchange  (NCE) in Green Bay, Wisconsin. NCE was a nonprofit corporation  established to be a market where surplus supplies of cheese were bought  and sold, and cheese had been traded there for over two decades. Cheese  producers generally use CME spot cheese market prices to set their sales  prices, according to industry participants. In turn, minimum prices for raw  farm milk bought by many cheese manufacturers are set using a U.S.  Department of Agriculture (USDA) pricing formula whose most significant  commodity component is the weekly average of cheddar cheese prices  drawn from a survey of large cheese manufacturing plants. Futures  contracts for milk used in manufacturing cheese are also settled at  expiration using the minimum price for milk as determined by the pricing  formula.
Some industry participants had hoped that moving the spot cheese market  would alleviate concerns about price manipulation. But during the last few  years, trade press articles have described ongoing concerns in the dairy  industry about potential price manipulation at the CME spot cheese  market and the potential effects on certain milk prices. Generally, price  manipulation is any planned operation, transaction, or practice that  intends to and causes or maintains an artificial price—that is, a price that  is higher or lower than it would have been if it had reflected the forces of  supply and demand. The Commodity Futures Trading Commission  (CFTC), which provides regulatory oversight of the CME because of its  futures markets and also has responsibility for enforcing a federal  prohibition against manipulating the price of any commodity in interstate  commerce, has received several complaints or allegations from industry  participants and others about price manipulation on the CME spot cheese  market. These concerns generally involve observed price fluctuations on  the CME spot cheese market and the possibility that these fluctuations  might result in prices that are too high or too low. Such concerns have  revived suspicions about the market’s susceptibility to manipulation and  raised questions about the effectiveness of the move from NCE in  addressing concerns about price manipulation and whether there is  sufficient regulatory oversight of the market.
Given these ongoing questions and the importance of the CME spot cheese  market in setting cheese and minimum milk prices in the United States,  you asked us to review the market’s operations, its susceptibility to  manipulation, and the role played by various oversight and enforcement  organizations in monitoring the spot cheese market. Specifically, we  examined (1) the structure and operations of the CME spot cheese market  compared to those of NCE and ongoing concerns about price  manipulation on the CME spot cheese market, (2) how the market is  regulated and efforts to address potential price manipulation, and (3) how  the CME spot cheese market impacts federal milk pricing.
To address these objectives, we reviewed industry and academic literature  regarding market operations and obtained information from CFTC, CME,  and market participants on the structure and operations of the CME spot  cheese market. We reviewed existing studies that assessed market  characteristics associated with price manipulation, examined available  trading data, and obtained officials’ views on potential manipulation. We  did not attempt to determine whether manipulation had occurred on the  CME spot cheese market; instead, we identified the characteristics of this  market that were consistent with those of markets considered susceptible  to price manipulation. We obtained and analyzed information about CFTC  and other oversight and enforcement organizations on their roles in  monitoring the CME spot cheese market. Finally, we obtained and  reviewed relevant laws and regulations related to milk pricing in the  United States as well as interviewed various agency and industry officials  about the role of CME spot cheese market prices in milk pricing. We  conducted our work between September 2006 and June 2007 in Chicago;  Washington, D.C.; and two locations in Wisconsin in accordance with  generally accepted government auditing standards.
subsections: section_title: Background
paragraphs: At any given time, participants in the cheese industry may have an interest  in buying or selling cheese for immediate delivery. Historically, they could  do so by identifying a buyer or seller through their contacts and  relationships in the industry or by participating in various centralized  markets throughout the United States where industry participants  gathered to buy and sell cheese. From 1974 to 1997, NCE was the central  market of, and functioned as a surplus market for, cheese. It also served  as the primary price discovery mechanism for cheese produced in the  United States.
In general, before 1987 cheese prices on NCE experienced little volatility,  because USDA purchased cheese to ensure that cheese prices did not fall  below a certain level. After mid-1988, the volatility of cheese prices  increased sharply because of lower price supports for milk, and NCE’s  role in price discovery took on additional importance until it closed in  1997. While price volatility does not indicate that manipulation is  occurring, the increased volatility in cheese prices, the corresponding  effect on milk prices, and a perceived lack of oversight of NCE raised  concerns about potential price manipulation. Following a series of  investigations and congressional hearings involving NCE, a joint  committee composed of a dairy industry trade group and NCE solicited  proposals for a new site for the spot cheese market. CME was selected and  the spot cheese market began operating there in May 1997. CME, the  largest futures exchange in the United States, is a publicly traded  corporation that offers a marketplace where various commodities such as  dairy products are traded through futures contracts or spot markets.  Various financial instruments are also traded on CME.
Like NCE, the CME spot cheese market functions as a surplus market for  cheddar cheese. Industry participants consider the CME spot cheese  market a public price discovery mechanism, and prices are published  daily. Contracts for the sale of all varieties of cheese in the United States  are generally set using the prices of cheddar cheese established at CME as  the reference price. For example, a contract may specify that cheese will  be sold based on the previous week’s average price of cheddar cheese set  at the CME. The contracts often include a premium or a discount on the  current price of cheddar cheese on CME based on factors such as the  quality and type of cheese and other costs such as transportation.
One of the federal programs designed to assist dairy farmers is the federal  milk marketing order (FMMO) program, which is designed in part to  improve the income of dairy farmers by stabilizing market conditions and  establishing minimum milk prices. Under this program, USDA uses  national dairy market price information—including cheese prices—to set  the minimum prices that processors must pay for unprocessed milk in  specified marketing areas or orders. FMMOs established a four-tier  classified pricing system for setting minimum milk prices on a monthly  basis, based upon the intended use of the milk. In general, FMMO class  prices are determined by formulas that use wholesale dairy product prices.  For example, the Class III milk formula uses monthly averages of weekly  average butter, cheese, and dry whey prices to set the minimum price of  milk that is used in the production of cheeses. According to one industry  participant, pricing a commodity based on the prices of products that the  commodity is used to produce is unusual. Prior to using the NASS survey  as a component to calculate minimum milk prices, USDA used cheese  prices from NCE directly as an input in its milk pricing formula. As  concerns were raised from industry sources and others about  manipulation of cheese prices at NCE, USDA developed the NASS survey  of cheese prices as an alternative to using NCE prices. In 1997, USDA  stopped using NCE prices in its minimum milk pricing formulas and began  using data provided by the NASS survey of cheese prices. USDA has  continued to use the NASS survey of cheese prices in certain milk pricing  formulas as trading in the spot cheese market occurred at the CME.
section_title: Certain Structure and Operations of CME Spot Cheese Market Are Similar to Those of NCE, and Certain Characteristics Result in Ongoing Concerns about the Potential for Price Manipulation
paragraphs: The CME spot cheese market shares a number of operational and  structural similarities with NCE and has certain characteristics that could  make the CME spot cheese market susceptible to price manipulation. Like  NCE, CME is primarily a surplus market where small amounts of blocks  and barrels of cheddar cheese meeting certain technical specifications are  traded. Many market participants that traded at NCE also trade at the CME  spot cheese market. Moreover, certain market conditions at the CME spot  cheese market, including a small number of trades and a small number of  traders who make a majority of trades, continue to make this market  particularly susceptible to manipulation.
subsections: section_title: Some Operational Aspects of the CME Spot Cheese Market Resemble Those at NCE
paragraphs: NCE and CME share many similarities, including certain trading rules,  products traded, the volume of cheese traded, and market participants, but  there are differences. According to CME officials, technical rules specific  to the CME spot cheese market were developed from the rules used to  operate NCE and rules already established by CME for an existing spot  butter market. For example, CME trades the same cheese products that  were traded on NCE—carloads of 40-pound blocks and 500-pound barrels  of cheddar cheese.  The CME spot cheese market continues to be a  surplus market for cheese on which relatively small amounts of cheese are  traded relative to the overall size of the U.S. cheese market. Unlike some  commodities, most cheese in the United States is traded through long-term  contracts, which generally use the CME spot cheese market price as the  reference price and previously used the NCE price.
NCE had between 30 and 40 members, including major participants in the  cheese and dairy industry, such as large agricultural cooperatives, cheese  manufacturers, and processors of cheese. These members accounted for  the vast majority of cheese handled and processed in the United States.  Likewise, major cheese and dairy industry members participate on CME,  including many companies that traded cheese on NCE. CFTC officials  estimated that 13 of the 31 CME spot cheese market participants  accounted for 60 percent of all cheese produced, processed, or marketed  in the United States in 2004. These participants in the spot cheese market  represent diverse segments of the cheese and dairy industries, including  dairy cooperatives representing many farmers and industry participants  that produce, manufacture, and process large quantities of cheese.
However, two differences exist between the CME spot cheese market and  NCE. First, the names of participants involved in NCE trading were made  public. Each member could designate up to five individuals as traders, and  the buyer and seller were reported for each trade. Trading at the CME spot  cheese market is conducted through a network of professional brokers,  the standard practice in many commodities, and the buyer and seller are  not publicly reported. However, according to some dairy industry  participants, they generally know which brokers represent specific buyers  and sellers. Second, trading on NCE occurred only once a week for one 30- minute session. Trading takes place at the CME spot cheese market every  weekday for at least 2 minutes and up to 16 minutes, depending on the  interest of market participants.
section_title: Thinness of the CME Spot Cheese Market, Combined with Other Factors, Contributes to Questions about Possible Price Manipulation
paragraphs: Despite the move to CME, the spot cheese market remains a thin market,  which in combination with the presence of a small number of traders that  make a majority of trades and the spot cheese market’s pricing structure  contributes to questions about the potential for price manipulation. A thin  market generally has either few transactions; transactions that represent  only a small proportion of the total transactions, including those that are  priced off that market; or both. CME and CFTC DMO officials, some  market participants, and academics generally agree that the CME spot  cheese market is a thin market. Little trading occurs on the CME spot  cheese market, and the trading that does take place consistently  represents a small proportion of the total volume of cheese produced in  the United States. According to CFTC officials, from 1998 to 2005, the  volume of cheese traded at CME generally represented less than 2 percent  of all cheddar cheese and less than 1 percent of all cheese produced in the  United States annually. This characteristic is not unique to the CME spot  cheese market, as other agricultural commodity markets, such as the CME  spot butter market, are also thinly traded. In addition, as shown in table 1,  on average only one or two transactions were completed during each  trading session in the barrel market, and the average was less than one for  most years, indicating that on some days no cheese was traded. The one  exception was 1997, when the average number of transactions on the  barrel market was more than eight, because the market did not have daily  trading at that time. Similarly, on average, fewer than three trades during  each trading session were completed in the block market each year.
Academic analyses and cheese and dairy industry participants have raised  a number of concerns associated with thin markets being susceptible to  manipulation. These concerns include the following:    Dominant traders may be able to attempt to manipulate prices more easily  in thin markets.
Prices in thin markets may not reflect supply and demand, even without  manipulative behavior by dominant traders.
As noted, thin markets raise concerns about the potential for manipulation  because of the small number of participants and transactions involved in  the market and the ease with which prices can be impacted. For example,  in thinly traded markets each individual participant’s activity tends to be  more influential than it would be on a market with more transactions and  more participants. As a result, it may be easier for a market participant to  move prices in a preferred direction over a short period of time with  relatively few completed or unfilled transactions. Further, individual  transactions to buy and sell cheese that set the market price may not  accurately reflect supply and demand.
Further, the CME spot cheese market has a small number of traders who  make the majority of trades, another factor that contributes to questions  about possible price manipulation. Relatively few market participants  account for the majority of trading at the CME spot cheese market, as  shown in figure 1. Between January 1, 1999, and February 2, 2007, two  market participants purchased 74 percent of all block cheese, and three  market participants sold 67 percent of all block cheese. During the same  time period, four market participants purchased 56 percent of all barrel  cheese, and two market participants sold 68 percent of all barrel cheese.
Other buyer (7)
Other eller (42)
Other eller (29)
In addition, the CME spot cheese market’s pricing structure, in  combination with a thinly traded market and a small number of traders  who comprise the majority of trading, contributes to questions about the  potential for price manipulation. As on many other financial markets,  prices at the CME spot cheese market are based on completed  transactions and on unfilled higher bids and uncovered lower offers that  are posted by market participants. During a trading session an unfilled  bid that is higher than the previous bid or transaction price can result in a  higher price. Similarly, an uncovered offer that is lower than the previous  offer or transaction price can result in a lower price. For example, on the  CME spot cheese market:    Between January 1, 1999, and February 2, 2007, the closing price for block  cheese fluctuated based on unfilled bids and uncovered offers on at least  17 percent of the trading days. During the same time period, the barrel  market closing price fluctuated based on unfilled bids and uncovered  offers 28 percent of trading days.
Between March 1, 2004, and April 16, 2004, block cheese prices increased  from $1.49 to $2.20 per pound, or 48 percent, on the CME spot cheese  market based primarily on unfilled bids to buy cheese, with only four  carloads of block cheese bought or sold during this period.
Between October 26, 2004, and November 19, 2004, block cheese prices  rose from $1.57 to $1.80 per pound, or 14 percent, with completed  transactions for only three carloads of cheese completed during this  period.
This pricing structure is not unique to the CME spot cheese market, and  price changes based on unfilled bids and uncovered offers may reflect  conditions consistent with supply and demand. However, this pricing  structure may increase opportunities to ultimately change the price of milk  without reference to the actual costs of buying and selling cheese.
Finally, although there may be characteristics that raise concerns about  price manipulation, certain characteristics of the CME cash cheese market  may reduce the risk of price manipulation. According to CME officials and  industry participants, the risk of incurring the expenses associated with  the actual buying or selling of cheese may deter some market participants  from attempting to manipulate prices at the CME spot cheese market. Any  CME spot cheese market participant who makes a bid or offer risks  acceptance of that bid or offer and the obligation to buy and accept  delivery of cheese or to sell and make delivery. Completed transactions for  the purchase or sale of cheese can involve a significant expense. While a  relatively small number of traders make the majority of trades, market  participants represent a significant amount of potential volume of trading.  CFTC has found that many large participants in the cheese and dairy  industry with diverse interests monitor the CME spot cheese market and  are prepared to participate in it. These large industry participants could,  for example, buy cheese on the CME spot cheese market if prices fell  below a company’s manufacturing costs or sell it if prices rose to a  profitable level, potentially countering any attempted manipulation.  Several industry participants we interviewed said that they believed that  price manipulation on this market would be difficult to sustain, given the  number of competing interests. Additionally, the change from once-a-week  trading on the NCE market to daily trading on the CME spot cheese  market may make sustaining attempted price manipulation more difficult  because a trader may have to be active in the market on a daily basis in  order to influence prices. Despite allegations of price manipulation,  industry participants we interviewed stated that they generally did not  believe manipulation was occurring. In addition, industry participants told  us that they never stopped using the CME price as a reference price in  their long-term contacts.
section_title: CFTC and CME Provide Increased Oversight of the CME Spot Cheese Market
paragraphs: Both CFTC and CME engage in activities that may detect or deter potential  price manipulation at the CME spot cheese market. Regular monitoring  by CFTC DMO and CME represents a significant change from the level of  oversight of NCE, which had received limited monitoring from CFTC and  NCE staff. CFTC, as part of its responsibility for the regulation of  commodity futures markets, monitors cash markets that affect futures  markets, such as the CME spot cheese market. CFTC surveillance staff  review trading activities on the market for manipulative activity, including  manipulation that may impact the Class III milk futures. Moreover, CFTC  Division of Enforcement can act on indications of manipulative activity  through CFTC’s authority to enforce the CEA, which specifically prohibits  the manipulation of prices of physical commodities in interstate  commerce. CME conducts daily surveillance of the CME spot cheese  market based on its established rules and internal procedures. Both CFTC  enforcement staff and CME investigate and, if appropriate, can take  enforcement actions in response to potential manipulative conduct on the  CME spot cheese market. However, proving price manipulation is difficult.
subsections: section_title: CFTC Monitors Trading Activity to Identify and Address Potential Price Manipulation on the CME Spot Cheese Market
paragraphs: In recent years, CFTC DMO staff have monitored the CME spot cheese  market on a regular basis both to review that prices of related Class III  milk futures contracts are consistent with forces of supply and demand  and in response to complaints alleging manipulative conduct. CFTC DMO  is particularly concerned about manipulative activities in cash markets  when prices on those markets could affect the integrity of futures contract  prices. The price paid for a Class III milk futures contract is based on the  monthly Class III milk price released by USDA, which is heavily influenced  by the price of cheese at the CME spot cheese market. Also, because the  CEA prohibits manipulating the price of any commodity in interstate  commerce, CFTC can take action under its enforcement authority to  investigate price manipulation of any commodity, regardless of whether it  is related to a futures contract. According to CFTC DMO officials,  however, CFTC surveillance staff would be unlikely to monitor  commercial activities involving a commodity without a related futures  market.
CFTC surveillance staff regularly obtain and analyze data on the activities  of the CME spot cheese market participants to assist in the detection and  also prevention of price manipulation in related futures markets. In 2005,  CME began providing CFTC with daily trading data and information on the  CME spot cheese market on a monthly basis. CFTC monitors traders with  large positions in Class III milk futures and the trades that these large  traders make in the CME spot cheese market. As part of its monitoring,  CFTC focuses on answering the following questions:  1.  Is the Class III milk futures price consistent with supply and demand  factors in the cheese industry?  2.  How is the monthly Class III milk price released by USDA behaving  compared to the CME spot cheese market and other cash prices?  3.  Are the largest Class III milk futures traders engaged in trades on the  CME spot cheese market that affect the monthly Class III milk price  released by USDA?  4.  Do the Class III milk futures traders have an incentive to engage in  losing trades on the CME spot cheese market in order to benefit a large  futures position?
In its market surveillance activities, CFTC surveillance staff may use many  sources of daily market information. Some of this information is publicly  available, including data on the overall supply, demand, and marketing of  the underlying commodity; futures, option, and cash prices; and data on  trading volume and open contracts. Some of the information is highly  confidential, including data from exchanges, intermediaries, and large  traders. CFTC Chicago surveillance staff generally review CME spot  cheese market transactional data from CME, which include the identities  of buyers and sellers and timing of trades, when they see unusual price  movements and to summarize the data for informational purposes. CFTC  surveillance staff may also interview industry participants, and interviews  may include discussions about basic market fundamentals, the traders’  involvement in specific commercial transactions, or the traders’  observations about anything unusual about the CME spot cheese market  or other cash transactions.
CFTC DMO staff have prepared summary documents analyzing the market  four times since 1999, including analyses of participants, volume, and price  fluctuations. Generally, they have found that the majority of the cheese  industry is represented at the CME spot cheese market and that trading on  the market is concentrated among a small number of participants.  CFTC  has filed no complaints related to price manipulation on this market.  These reviews represent another change from NCE, which, according to  CFTC officials, CFTC did not monitor regularly. CFTC did review trading  activities on NCE in 1997 prior to approving a market for trading in certain  milk futures. This review did not identify significant deficiencies or  suggest that the market was susceptible to manipulation. In contrast, after  a 4-year investigation in which confidential and proprietary information  was gathered, University of Wisconsin economists found that the  organization of NCE appeared to facilitate market manipulation, but could  not definitively conclude that manipulation had occurred, and that NCE  was not an efficient price discovery mechanism between 1988 and 1993.  Market participants told us that CFTC monitoring of the CME spot cheese  market addressed some of their concerns about limited oversight of  trading at NCE.
In addition to identifying unusual activities or manipulative conduct  through its monitoring activities, CFTC also responds to complaints and  concerns raised by industry members and the public. CFTC surveillance  staff in Chicago collaborate with CME officials to examine trading  activities. Since 1999, CFTC Chicago DMO staff have done nine special  reviews of trading activity at the CME spot cheese market in response to  specific complaints or fluctuations in market prices. These complaints  dealt with issues including an allegation that a market participant failed to  pay in a timely manner for cheese purchased on the CME spot cheese  market, allegations of price manipulation on that market, and concerns  about price volatility on that market. According to CFTC officials, the  CFTC market surveillance analyst responsible for the Class III milk futures  market reviewed these complaints, analyzed the time period or market  participants involved in the allegation, and responded to the party that  complained. None of these reviews resulted in any legal action taken by  CFTC against a market participant. According to trade press reports,  CFTC is currently investigating the trading activity of one participant in  the CME spot cheese market for potential manipulation of the market.  Unless otherwise authorized, CFTC regulations require enforcement  investigations to be nonpublic. Therefore, CFTC does not confirm, deny,  or comment about possible ongoing investigations.
According to CFTC DMO officials, CFTC generally would not take an  active role in oversight of the CME spot cheese market without a related  futures market because of its interpretation of its responsibilities under  CEA and limited resources. However, other federal agencies have  responsibilities relating to the manipulation of cash cheese prices even in  the absence of a related futures contract. The U.S. Department of Justice  (DOJ) has responsibility for investigating possible violations of the  antitrust laws and taking appropriate legal action in the courts. DOJ’s  authority includes taking action based on unreasonable restraints of trade  such as price fixing or manipulation. In addition, the Federal Trade  Commission (FTC) is charged by statute with preventing unfair methods  of competition and unfair or deceptive acts or practices in or affecting  commerce. In order to avoid duplicating efforts to pursue allegations of  anticompetitive behavior or price fixing, the two agencies developed and  maintained a liaison arrangement to determine who would take the lead  on any cases involving the CME spot cheese market.
Certain other federal and state agencies that observed or monitored  trading at NCE no longer do so at the CME spot cheese market. In the  past, USDA officials observed trading and published prices established at  NCE but do not observe CME spot cheese market trading. Prices are now  publicly reported. USDA officials did not provide oversight of NCE and  have no oversight role of CME. NCE was also subject to the Wisconsin  Department of Agriculture, Trade and Consumer Protection’s jurisdiction  over unfair competition and trade practices. According to CME officials,  no state agency has a role in overseeing CME or the CME spot cheese  market.
In addition to monitoring trading in the futures markets and related cash  markets, CFTC has general authority, provided by the CEA, over  designated contract markets. CME, as a designated contract market, must  demonstrate to CFTC that it meets CEA criteria for the prevention of  market manipulation, fair and equitable trading, the conduct of trading  facilities, and the financial integrity of transactions. In addition to  providing market surveillance, CFTC DMO approves and oversees the  futures exchanges, including CME, and reviews exchange rules. CFTC  also assesses the effectiveness of compliance and market surveillance  capabilities and reviews new futures contracts to assess their  susceptibility to manipulation. To ensure the market’s financial integrity,  CFTC Division of Clearing and Intermediary Oversight reviews the audit  and financial surveillance activities of self-regulatory organizations (SRO),  including CME. According to CFTC officials, they have not approved  CME spot cheese market rules. However, CFTC conducted a rule  enforcement review of CME that covered the time period October 2004 to  October 2005. This review, which did not specifically include the CME  spot cheese market rules, included an examination of the compliance of a  number of CME’s programs with CEA, including the audit trail, trade  practice surveillance, disciplinary, and dispute resolution programs. CFTC  did not make any recommendations for improvements in these areas.
Proving actual or attempted price manipulation is difficult, according to  CFTC officials. They noted that CEA does not have a specific definition  of manipulation. Rather, it has been left to the courts to develop the law  through cases or decisions. Accordingly, as established by federal courts  and CFTC, proving manipulation requires being able to show the  following:    The market participant had the ability to influence market prices.
The market participant specifically intended to influence prices.
Artificial prices existed.
The market participant caused an artificial price.
Proof of an attempted manipulation requires sufficient evidence of (1) an  intent to affect the market price and (2) some overt act in furtherance of  that intent. Like the test for manipulation, the test for attempted  manipulation depends upon the facts and circumstances of a particular  market and its participants. We did not find any studies or court cases  that have concluded that there has been manipulation on the CME spot  cheese market or NCE.
An intent to raise or lower CME spot cheese market prices could be based  on a variety of incentives. For example, farmers that produce milk used to  manufacture cheese benefit when the price of cheese on the CME spot  cheese market is high because the CME spot cheese market influences a  broad array of cheddar cheese prices that are included in the pricing  formula for Class III milk. Alternatively, a company that largely sells  cheese purchased from others could benefit from low CME spot cheese  market prices. This is because most cheese plants from which it buys  would be using the lower CME cheese prices to set their contract price,  but it would sell its cheese at a price not based on CME prices. These  factors alone do not imply that price manipulation has occurred—in fact,  price manipulation has not been proven—but these incentives appear to  contribute to ongoing questions about the susceptibility of the market to  manipulation relative to one with more trading or more market  participants comprising the majority of trades.
Further, identifying actual or attempted manipulation on the CME spot  cheese market can be difficult for a number of other reasons. First,  because the CME spot cheese market functions as a market to dispose of  excess supply or to fill temporary inventory needs, it may not always  reflect prices that are consistent with supply and demand in the broader  market as market participants attempt to manage short-term inventory  needs through the CME spot cheese market. For this reason, determining  what constitutes an artificial price can be difficult. In addition, companies  may attempt to influence prices without considering their activity to be  manipulative. For example, according to one industry participant, traders  may act to influence the spread between the prices of barrel cheese and  block cheese to keep it in line with general historical trends. Finally,  USDA officials and industry participants told us that some market  participants used the CME spot cheese market as a forum to “register an  opinion” on what they believed cheese prices should be by making bids  and offers with the intent to change the price of cheese to more closely  align with their opinions of supply and demand conditions.  Representatives of two market participants we interviewed said that they  did not believe that this activity constituted manipulation on the CME spot  cheese market. However, CFTC enforcement officials disagreed and  believe that the types of behavior described above may constitute  manipulative behavior.
section_title: CME Conducts Daily Surveillance of the CME Spot Cheese Market
paragraphs: CME rules govern its oversight of the CME spot cheese market. CME, as  an SRO, is responsible for establishing and enforcing rules governing  member conduct and trading; providing for the prevention of market  manipulation, including monitoring trading activity; ensuring that futures  industry professionals meet qualifications; and examining exchange  members for financial strength and other regulatory purposes. CME rules  authorize the managing director of regulatory affairs to enforce CME rules  and gather all the information necessary to investigate abuses of trading  practices. Through this authority, CME monitors trading activities, collects  data on its markets, and inspects the books and records of members. In  addition, the managing director of regulatory affairs may investigate and  recommend institution of disciplinary proceedings for alleged violations of  CME rules.
CME conducts surveillance and investigations of the CME spot cheese  market through its market regulation division. CME’s market regulation  division employs market surveillance analysts, one of whom is assigned to  monitor the CME spot cheese market, among others. According to CME  officials, the market surveillance analyst assigned to the CME spot cheese  market monitors daily trading, maintains familiarity with traders and  industry news and trends, and reviews large price changes resulting from  uncovered bids or offers and determines the identity of market  participants. The analyst reviews and analyzes spot call cheese trade  activity in relation to Class III milk futures positions. The analyst, along  with market regulation staff, handles inquiries and complaints from  market participants and firms, contributes to contract specification  changes and rule language updates, and regularly participates in  problematic delivery-related issues. The analyst physically observes  trading at the CME spot cheese market on average three times a week. In  addition, the analyst reviews the input of daily trading data into a CME  database to ensure that trades are properly recorded and that clearing  member firms verify their assigned transactions and provide buyer and  seller identification and relevant delivery details.
In addition to employing market surveillance staff, CME assigns one  investigator to regularly review the CME spot cheese market to identify  potential violations of trading practices and determine if trader activity is  adversely affecting Class III milk futures. According to CME officials, they  have investigated trading activity related to delivery of cheese sold on the  CME spot cheese market and have disciplined two traders. However, CME  officials told us that CME has only rarely opened formal investigations into  traders on the spot cheese market for rules violations. This surveillance is  stricter than at NCE, which had rules against manipulating prices but no  staff to oversee the market and generally did not investigate trading  activities.
According to CME officials, CME market regulation staff also review  traders’ positions and activities in the CME spot cheese and Class III milk  futures markets to determine if a trader’s futures positions would benefit  from price changes on the spot cheese market. For example, the market  surveillance analyst may look for trading activity on the CME spot cheese  market that might directly benefit a trader’s futures positions, such as  selling cheese in order to lower prices and benefit a short position in Class  III milk futures. The market surveillance analyst for the CME spot cheese  market also reviews trading data from both markets for large price  changes and market trends.
Finally, CME annually provides a dairy forum for CME spot cheese market  participants to meet and discuss potential improvements to the spot  cheese market. Forum meetings have included discussion of such topics  as electronic trading, anonymous trading, daily limits on trading, and  technical specifications for products traded. Working committees have  been formed based on these meetings, and CME staff told us that they  would focus on potential improvements that received majority support as  expressed at the forum.  According to market participants, regular  monitoring and oversight of the CME spot cheese market by CME officials  has addressed certain industry concerns about potential price  manipulation that existed when NCE operated the spot cheese market.
section_title: The USDA Survey of Cheddar Cheese Prices Largely Duplicates CME Cheese Prices and Introduces a Time Lag into Some Milk Prices
paragraphs: The NASS survey of cheese prices, which is a major determinant of some  FMMO minimum milk prices, is not currently audited by USDA, largely  duplicates reported CME cheese market prices, and introduces a 1- to 2- week time lag between when data are reported by NASS and when  transactions captured in the survey occur. USDA used to rely on the price  of 40-pound blocks of cheddar determined on NCE in pricing milk, but  developed the NASS survey of cheese prices in response to concerns,  raised by industry and others, about a thin market and the potential for  price manipulation on NCE. As stated by the Secretary of Agriculture at a  hearing before a subcommittee of the U.S. Senate Committee on  Appropriations in March 1997, USDA began conducting a national survey  of cheddar cheese prices in response to concerns about the accuracy of  reported prices at NCE. The NASS survey of cheese prices is intended to  capture more transactions than those occurring on the CME spot cheese  market. According to USDA officials, the NASS survey of cheese prices  has continued to be used in the milk pricing formula. However, USDA’s  ongoing reliance on the survey raises three issues. First, USDA does not  audit the data reported in the NASS survey of cheese prices to ensure the  accuracy of the prices reported. Second, industry participants use the  CME spot cheese market price as a reference price, and survey results and  CME spot cheese market prices rarely differ significantly. Third, the timing  of the survey introduces into certain milk prices a 1- to 2-week time lag  between when data are reported by NASS and when transactions captured  in the survey occur. Figure 2 provides an overview of how CME spot  cheese prices influence milk pricing.
USDA began using NASS survey cheese data as an input into milk pricing  formulas after NCE closed. Since USDA began using data from the NASS  survey of cheese prices in its milk pricing formula, the agency has held  hearings in response to industry concerns about the pricing formulas for  Class III milk. Some industry participants have put forth a number of  proposals related to eliminating the use of the NASS survey of cheese  prices in milk pricing, including proposals in 2000 and 2006, that  recommended eliminating the use of the NASS survey and instead using  CME spot cheese market prices in the milk pricing formulas. In 2000, in  hearings on milk order reform, industry opinions varied on the use of CME  cheese prices instead of the NASS survey of cheese prices, with some  industry participants stating that they preferred the use of the NASS  survey of cheese prices. USDA decided to continue to use the NASS survey  of cheese prices, stating that the NASS survey prices are based on a much  greater volume than using CME prices. As of June 2007, hearings were still  being held regarding the more recently submitted proposal, which  recommended using CME prices instead of NASS survey prices. A final  regulation would be subject to industry approval requirements contained  in the statute. USDA officials have told us that historically there has been  a lack of consensus in the industry to make this change. Several milk  producers and cheese manufacturers we interviewed stated that they  generally supported the idea of no longer using NASS survey prices in the  milk pricing formulas. In order to assess the potential impact of current  proposed changes to the Class III milk pricing formulas, the USDA  conducted preliminary economic analyses, which analyzed the change to  historical Class III milk prices if CME spot cheese market prices had been  used instead of the results of the NASS survey of cheese prices. On the  basis of this analysis, USDA concluded that using the CME spot cheese  market prices instead of the NASS survey of cheese prices would lead to a  difference of little significance.
Under the milk marketing orders, NASS collects dairy market prices, such  as the NASS survey of cheese prices, for use in USDA’s milk pricing  formulas, which raises three issues. First, USDA does not currently audit  responses provided by survey participants. Under the Dairy Market  Enhancement Act of 2000, mandatory price reporting requirements for  dairy products used in setting milk prices were established. Additionally,  USDA was authorized to conduct audits of transactions reported by survey  participants. Auditing the transactions could help to ensure the accuracy  of the information used to establish minimum milk prices under the  FMMOs. However, USDA does not currently audit these transactions,  which include transactions captured in the NASS survey of cheese prices.  Agency officials told us that they had developed a proposed rule to  conduct audits of the data. According to a USDA official, the proposed  rule is currently under review by the Office of Management and Budget.  Recently, USDA disclosed that there had been a reporting error in the data  included in its survey of nonfat dry milk prices. According to USDA  officials, this error affected milk prices for farmers for at least 2 months  and caused a market loss of at least $6.4 million. Without auditing the data  provided in the NASS survey of cheese prices, USDA cannot ensure the  accuracy of the data that are used in the milk pricing formulas.
Second, although USDA officials told us that the NASS survey captured a  wider range of cheese prices than using prices from the CME spot cheese  market, the survey captures the weekly average CME spot cheese market  price because cheese manufacturers use the CME spot cheese market  price as a reference price plus or minus a premium or discount depending  upon the specifications of the cheese. As a result, price manipulation on  the CME spot cheese market, if reflected in the NASS survey, could lead to  certain federal order minimum milk prices being artificially high or low.  Despite surveying a broader range of transactions, the survey provides  limited additional information beyond what is already available directly  from the CME spot cheese market and results in a high correlation  between the NASS survey of cheese prices and CME spot cheese market  prices (see fig. 3). According to a University of Wisconsin study, the NASS  survey has a 98 percent correlation with CME spot cheese market prices  when adjusted to account for the difference in timing between collecting  price information and publishing survey results. USDA has generally not  analyzed differences between the NASS survey prices and CME spot  cheese market prices such as those in figure 3. Additionally, while industry  participants recognize the role of the NASS survey of cheese prices in  setting certain minimum federal order milk prices, industry participants  we interviewed said the survey did not provide them with useful  information. Industry participants told us that small differences between  the two price series are likely due to premiums and discounts negotiated  into contract prices, such as for transportation costs.
The third issue raised by USDA’s use of the NASS survey of cheese prices  is that the results are not released for 1 to 2 weeks after certain  transactions captured in the survey occur. California Department of Food  and Agriculture officials told us that California does not participate in  FMMOs. They also told us that California does not rely on the NASS  survey, in part because of concerns about the timing of the survey.  Additionally, although industry members we interviewed stated that the  effects of the time lag may balance out over time, they said that the use of  the NASS survey created short-term problems in milk pricing because of  the time lag. For example, one industry member said that because of a  timing lag that can occur during periods of rapidly declining cheese prices  at the CME spot cheese market, USDA minimum milk prices may not fully  reflect current milk prices. As a result, cheese manufacturers may be  buying milk based on prices calculated using higher cheese prices from  the preceding weeks but selling cheese at current lower market prices.  This is due in part to the time lag in the NASS survey of cheese prices and  could cause, in the short term, losses for the manufacturer. However, dairy  farmers may benefit in this example. In periods of rapidly rising cheese  prices, the time lag could result in dairy producers receiving less for their  milk than if current market conditions were reflected in the minimum milk  prices. In this example, cheese manufacturers might benefit.
According to USDA officials, the effect of the time lag inherent in the  NASS survey of cheese prices on Class III milk prices is diminished by two  factors. First, USDA publishes the minimum Class III milk price on a  monthly basis, and according to USDA officials, this dilutes the effect of  the time lag on the Class III minimum milk price. Second, according to  USDA, 75 percent of milk is sold with a premium over the Class III  minimum milk price, and these “over-order” premiums reduce the effect of  the time lag in the Class III minimum milk price. However, monthly Class  III minimum milk prices can sometimes be based on data that do not  include a portion of or the entire last week of NASS survey of cheese data  for that month. This can be compounded because industry participants  sometimes base their cheese prices on the prior week’s CME spot cheese  market price. As a result, the effect of the time lag would be present in the  monthly Class III milk price. Moreover, according to some industry  participants we interviewed, the Class III minimum milk price is used by  industry participants as the base price onto which over-order premiums  are applied. This means that if the minimum milk price is too high or too  low because of the effect of the lag, the lag would be reflected in milk  prices set by industry participants who start with the minimum price and  add a premium. Therefore, the time lag may result in industry members  paying or receiving prices for milk that no longer fully represent current  market conditions.
section_title: Conclusions
paragraphs: The move from NCE to CME changed little about the structure or function  of the spot cheese market but has increased oversight. The CME spot  cheese market continues to be a surplus market where a few large  participants buy and sell cheese and less than 1 percent of the cheese  produced in the United States is traded. In addition, market participants  continue to use CME spot cheese market prices to set most cheese prices  in the United States. As a result, concerns about price manipulation will  likely remain. However, monitoring of trading activity by CFTC DMO and  CME represents a substantial increase in the level of oversight of the CME  spot cheese market as compared to oversight of NCE. This has addressed  some concerns about potential price manipulation on the CME spot  cheese market. While not guaranteeing that price manipulation will be  detected or prevented, regular and targeted reviews may help to ensure  the integrity of and confidence in the market.
The CME spot cheese market also impacts minimum milk prices through  the NASS survey of cheese prices, which largely captures the CME spot  cheese price but with a 1- to 2-week lag. USDA developed the NASS survey  of cheese prices, in part to address industry and other concerns about a  thin market and potential price manipulation. However, despite surveying  a broader range of transactions, the industry uses the CME spot cheese  market as the primary mechanism for price discovery and for pricing the  majority of cheese sold. As a result, the NASS survey continues to capture  largely redundant spot cheese market prices. Any small difference  between prices from the NASS survey and CME spot cheese prices may be  due to factors such as a time lag between data collection and price  reporting, premiums or discounts on the CME price, or errors in data  collected in the NASS survey of cheese prices. In addition, the NASS  survey data are not currently audited by USDA, and a recent error in  nonfat dry milk prices has raised questions about the accuracy of the data  reported. California, with one of the largest dairy industries in the country,  has chosen to use CME cheese prices over NASS survey of cheese prices  in its milk pricing formula because officials believe they more accurately  reflect current market conditions. The NASS survey of cheese prices  largely captures CME price data by surveying producers versus capturing  current data directly from CME. A lag of 1 to 2 weeks exists in data  collected in this survey. As a result, industry participants may be paying  prices for milk that may not be current.
section_title: Recommendations for Executive Action
paragraphs: As USDA continues to hold hearings on a variety of issues, including the  Class III milk pricing formula, we acknowledge that there may be a variety  of proposals to consider.  To improve the timeliness of reported cheese  prices and reduce redundancy that exists in the NASS survey of cheddar  cheese, we recommend that the Secretary of USDA direct the  Administrator, Agricultural Marketing Service to give serious  consideration to all proposals, in consultation with the industry, including  the industry proposal to use the CME spot cheese market prices instead of  the NASS survey of cheese prices in the minimum federal milk pricing  formula.
If USDA continues to use the NASS survey of cheese prices, we  recommend that the Secretary of USDA direct the Administrator, AMS, to  implement in a timely manner a program to audit data reported to NASS in  its survey of cheese prices.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to CFTC, USDA, and CME.  We received  written comments from USDA, which are reprinted in appendix II.  We  also received technical comments from CFTC, USDA, and CME, which  have been incorporated where appropriate.  In written comments from the  Under Secretary of Marketing and Regulatory Programs, USDA agreed  with our recommendation intended to ensure that AMS implements a  program to audit data reported to NASS in its survey of cheese prices.   However, the agency disagreed with our recommendation to proactively  consider, in consultation with the industry, the industry proposal to use  CME spot cheese market prices instead of NASS survey of cheese prices in  the minimum federal milk pricing formula.
In response, USDA noted, as we do in the report, that it is in the process of  holding a hearing addressing proposed changes to the federal milk  marketing order minimum price formulas and that using the CME spot  cheese price is among the proposals.  According to USDA, it is outside of  USDA’s authority to “proactively consider” proposals to change federal  milk marketing order provisions.  We have, therefore, clarified our  recommendation.  We were not and are not recommending that USDA  take action outside of its current authority and we recognize that USDA  must follow its rules of practice and procedure when conducting  proceedings to amend marketing orders.  Specifically, USDA states that  proposals to use the CME price will be given “due consideration, weighing  both the supporting and opposing testimony” in the hearing process.  Our  recommendation is that USDA give serious consideration to all proposals,  in consultation with the industry, including the industry proposal to use  the CME spot cheese market prices instead of the NASS survey of cheese  prices in the minimum federal milk pricing formula.
USDA also stated that because concerns remain about potential  manipulation at the CME spot cheese market, “use of the NASS price to set  FMMO minimum prices seems prudent until an alternative is shown to be  clearly superior.”  While we recognize that there are potentially a variety of  ways to price Class III milk, the use of CME spot cheese market prices has  certain merits over using NASS prices.  As stated in our report, while  concerns remain about price manipulation at the CME spot cheese market,  the NASS survey of cheese prices does not address these concerns.  The  NASS survey of cheese prices largely duplicates CME spot cheese market  prices.  Use of CME spot cheese market prices instead of NASS survey of  cheese prices could reduce redundancy.  As USDA itself has found, the  long-term difference in using CME spot cheese prices instead of NASS  survey of cheese prices in milk pricing is close to zero.  This is because, as  we note in our report, the cheese industry uses CME spot cheese prices to  set contract prices.  As a result, CME spot cheese market prices are  captured by the NASS survey of cheese prices.  Further, industry  participants that we interviewed stated that they have not adjusted how  they set contract prices due to concerns about manipulation on the CME  spot cheese market.  Therefore, any pricing concerns about CME would  also be reflected in the NASS survey prices.
USDA further stated that GAO has not demonstrated that there has been a  loss or benefit to cheese makers due to the time lag associated with  calculating a monthly average federal minimum milk price.  However, the  report does include an example of a potential loss to cheese makers.  As  stated in the report, one industry member we interviewed told us that  during periods of rapidly declining cheese prices at the CME spot cheese  market, the timing lag may result in USDA minimum milk prices not fully  reflecting current milk prices and may result in cheese makers buying milk  at prices higher than the prices at which the cheese maker sell its cheese.   Additionally, we clarified in the report that industry participants we  interviewed that told us the NASS survey made their business more  complicated were referring to short-term problems in milk pricing due to  the use of the NASS survey and the corresponding time lag.  Moreover, the  time lag is one reason why California does not rely on the NASS survey of  cheese prices.  Finally, USDA comments included an overview of  minimum milk prices and the manufacturing plant relationship with the  FMMO.
As agreed with your office, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 14 days from the  report date.  At that time, we will send copies of this report to the  appropriate committees.  We will also send copies to the Chairman of  CFTC, the Secretary of Agriculture, and the Managing Director, Regulatory  Counsel of CME.  We also will make copies available to others upon  request.  In addition, the report will be available at no charge on the GAO  Web site at http://www.gao.gov.
If you or your staff have any questions concerning the report, please  contact me at (202) 512-8678 or williamso@gao.gov, or John Wanska,  Assistant Director, at (312) 220-7628 or wanskaj@gao.gov.  Contact points  for our Offices of Congressional Relations and Public Affairs may be found  on the last page of the report.  Key contributors to this report are listed in  appendix III.
section_title: Appendix I: Scope and Methodology
paragraphs: To review the structure and operations of the Chicago Mercantile  Exchange (CME) spot cheese market, we obtained and analyzed  information about CME, including internal rules and procedures that  govern the market. We compared this information to the National Cheese  Exchange’s (NCE) rules and procedures, as well as to federal and  academic analyses of the structure and operations of NCE. We obtained  and reviewed industry and academic literature regarding market structure.  To analyze concerns about price manipulation, we reviewed existing  studies that assessed market characteristics associated with price  manipulation. In addition, we obtained and analyzed spot cheese market  trading data provided by CME. To assess the reliability of the CME data,  we reviewed the data and interviewed CME officials, and determined that  the data were sufficiently reliable for our purposes. Using the data  provided, we calculated summary statistics on volume of trading, number  of market participants, and the role of uncovered bids and unfilled offers.  We also obtained Commodity Futures Trading Commission (CFTC) and  CME officials’ views as well as those of market participants and members  of the cheese and dairy industry on the potential for price manipulation at  the CME spot cheese market and NCE. We did not attempt to determine  whether manipulation has occurred on the CME spot cheese market;  instead, we identified the characteristics of this market that are consistent  with those of markets considered susceptible to price manipulation.
As a part of our review of market monitoring and oversight, we obtained  and analyzed information about CFTC, CME, and other oversight and  enforcement organizations on their role in monitoring the CME spot  cheese market. In addition, we interviewed officials from CFTC’s Division  of Market Oversight, Division of Enforcement, and Office of General  Counsel to obtain information about CFTC’s role in the CME spot cheese  market. We also interviewed CME officials from its Legal and Market  Regulation Division, Corporate Development Division, and Products and  Services Division to discuss CME’s oversight of the CME spot cheese  market.
To review how the CME spot cheese market impacts federal minimum  milk prices, we obtained and reviewed federal laws and United States  Department of Agriculture (USDA) regulations governing the federal milk  pricing formulas. We also reviewed academic analysis of the role the spot  cheese market has in milk pricing. In addition, we interviewed officials  from USDA’s Agricultural Marketing Service and National Agricultural  Statistical Service as well as numerous academics who study issues of  dairy policy. We also interviewed market participants and members of the  cheese and dairy industry on the relationship between the CME spot  cheese market and minimum federal milk prices. Members of the dairy and  cheese industry included cheese manufacturers, dairy cooperatives,  processors of cheese, and milk producers.
section_title: Appendix II: Comments from the Department of Agriculture
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to those individuals named above, John Wanska, Assistant  Director; Marta Chaffee; Emily Chalmers; Jay Cherlow; Alison Martin;  Marc Molino; Andy Pauline; and Paul Thompson made key contributions  to this report.