Trade options are off-exchange commodity options which can be offered only to a commercial person or entity solely for purposes related to the commercial's business as such. They are currently prohibited on certain agricultural commodities. Several policy alternatives are analyzed in connection with this prohibition. Certain other issues relating to off-exchange instruments in these agricultural commodities also are analyzed.

II. ANALYSIS OF THE ECONOMIC FUNCTIONS OF RISK-MANAGEMENT AND MERCHANDISING CONTRACTS.

Agricultural prices are subject to significant fluctuations. In order to hedge against this risk, merchandising contracts known as forward contracts were developed. From these contracts, exchange-traded futures and option contracts, which separated risk-management from merchandizing functions, evolved. Both customized, off-exchange contracts and standardized, exchange-traded futures and option contracts offer benefits.

The market for agricultural products, where supply and demand are inelastic, is characterized by large changes in prices. Those price changes create price risk against which those engaged in agriculture seek protection. In response to this price volatility, risk management instruments were developed to offer buyers and sellers a hedge against price uncertainty. Initially, forward contracts combined risk shifting with merchandising features. Once trading in such contracts became established, futures and options contracts were developed to perform solely a risk-shifting function.

III. THE REGULATORY ENVIRONMENT.

Federal regulation of futures trading, from its inception, has differentiated between exchange-traded and off-exchange instruments. Moreover, it has differentiated regulation of risk-shifting contracts from forward contracts, which are individually negotiated and perform both merchandising and risk-shifting functions. Through the years, commodity option contracts have traded legally both on and off exchange, have been prohibited from being traded either on or off exchange and have been subject to varying regulatory treatment. The history of the regulation of commodity option trading is complex and, at times, the regulatory treatment of options has differed depending on the underlying commodity.

IV. RECENT DEVELOPMENTS IN AGRICULTURE EXPAND THE NEED FOR, AND THE USE OF, RISK-SHIFTING STRATEGIES.

Agricultural markets in the U.S. are undergoing profound changes. These changes increase uncertainty in agricultural markets and expand the need for risk-shifting strategies. For example, crop deficiency payments, which previously played a major role in stabilizing farm incomes, have been eliminated along with planting restrictions. In addition, changes in international markets will have an uncertain impact on U.S. agriculture.

The above trends are producing greater uncertainty and price volatility in the agricultural markets. Although producers, in the past, frequently refrained from using risk-shifting strategies, increasing volatility will require their greater use. New forms of risk-shifting instruments are being developed in response to the increased demand.

V. BENEFITS OF OFF-EXCHANGE AGRICULTURAL TRADE OPTIONS.

In general, option contracts give hedgers a unique risk-management tool with a known cost. Off-exchange options enable hedgers and risk managers to customize the terms of the contract better to meet particular needs. Lifting the ban on agricultural trade options potentially increases the supply of, and competition in offering, agricultural options.

This may result in greater convenience for producers by permitting a variety of option vendors. The added source of vendors may reduce various costs to option users of obtaining information relating to their market decisions. In addition, customized option contracts permit more precise matching of hedges to amount, timing and other commodity characteristics. Moreover, buyers of trade options may be able to finance the purchase through an arrangement with the seller. The availability of customized trade options also moves the markets toward market completion.

VI. RISKS OF TRADE OPTIONS.

While trade options offer many of the same economic benefits as exchange-traded options, the two markets differ markedly in terms of protections and how contracts are traded. In evaluating trade options, six sources of risk cause heightened concern: fraud, credit risk, liquidity risk, operational risk, systemic risk and legal risk.

While many advantages may be associated with trade options, they also bring the potential for a higher incidence of fraud. This potential arises mainly from the current unregulated nature of the option vendors either by direct government oversight or by a self-regulatory organization, from the lack of a developed regulatory framework governing trade options' offer or sale and from a potential lack of transparency of their pricing. Finally, agricultural trade options may be sold in an environment where purchasers do not have previous experience with, or understanding of, their use.

Credit risk is the risk that the counterparty to a contract will be unable to perform on all or a portion of its obligations. The credit risk associated with over-the-counter contracts is generally a more significant concern than with exchange-traded contracts, and one must be more aware of the financial condition of counterparties.

Liquidity describes the ability to execute a transaction quickly without affecting the price. As with most privately negotiated contracts, holders of trade options face a high degree of liquidity risk. Operational risk relates to the ability to monitor and maintain control over an enterprise. Specifically, this risk relates to the ability to understand the terms of a contract, to monitor its market value, to assess how the contract interacts with other areas of the enterprise at any particular time, and to respond quickly to changes in the marketplace.

Systemic risk, or the risk of widespread financial disruptions, may be particularly problematic in rural economies which tend to be isolated and are highly dependent on agriculture. Finally, enterprises which choose to operate under an exemption, such as the trade option exemption, must carefully conform their activities to fit within the terms of the exemption or risk finding that their conduct violates that, or some other, legal provision.

VII. POSSIBLE REGULATORY RESTRICTIONS TO ADDRESS POTENTIAL RISKS.

Removing the current ban on agricultural trade options has both potential benefits and risks. One approach to striking an appropriate balance between the two would be to lift the prohibition subject to conditions. Appropriate conditions might include restrictions on permitted parties, restrictions on the instruments or their use and/or regulation of their marketing.

One means of addressing several of the risks noted above would be to impose eligibility limitations, such as to restrict the availability of agricultural trade options to sophisticated individuals or entities; to require that those selling these instruments be registered with, or identify themselves to, the Commission or be commercials themselves; and/or to impose an education requirement on either or both buyers and vendors of the instruments.

Restrictions on the instruments might be considered as a means of ensuring that commercials enter into such transactions "solely for purposes related to [their] business as such." Moreover, the regulation of marketing may be appropriate. Such regulation might include disclosure requirements and account confirmation requirements. Additional possible limitations include requirements for cover or other methods for addressing risk of possible default and requirements regarding the establishment of appropriate internal controls.

VIII. RELATED ISSUES.

A number of issues have been raised regarding the applicability of other exemptions to agricultural contracts. Care should be taken in distinguishing these issues from those relating purely to trade options.

Although free-standing trade options on the enumerated agricultural commodities have been prohibited, option-like payment features previously have been permitted by staff interpretation when embedded in a merchandising (forward) contract. Care should be taken to distinguish these contracts from trade options.

In addition, the applicability of the prohibition on agricultural options to the Commission's exemption for certain swap agreements was not explicitly addressed by the Commission when it promulgated the swaps exemption. That issue should be addressed.

Finally, the Commission has promulgated rules permitting a "Professional Market" to be traded under a reduced regulatory regime in order to give exchange markets an opportunity to develop new and innovative trading mechanisms. The enumerated agricultural commodities have not been included within that program.

IX. RECOMMENDATIONS.

The Division of Economic Analysis, based upon the analysis which follows, recommends that the Commission undertake the following five actions:

1. Deny the petition to adopt as final the agricultural trade option rules proposed in 1991.

2. Consider lifting the agricultural trade option prohibition subject to appropriate conditions.

3. Publish in the Federal Register an Advance Notice of Proposed Rulemaking.

4. Confirm that the prohibition on agricultural trade options does not limit the scope of the swaps exemption.

5. Update and reissue the 1985 Office of General Counsel (OGC) interpretation on agricultural forward contracts.

TABLE OF CONTENTS

I. SCOPE OF THIS ANALYSIS. 1

II. ANALYSIS OF THE ECONOMIC FUNCTIONS OF RISK-MANAGEMENT AND MERCHANDISING CONTRACTS. 5

A. Price volatility and price risk in agricultural markets. 5

B. The development of merchandising and risk management instruments. 7

1. Development of marketing and risk-shifting contracts. 7

2. Development of separate risk-shifting contracts. 8

III. THE REGULATORY ENVIRONMENT. 11

A. Comparison of regulation of futures and forwards. 11

B. The regulation of commodity options has a complex history. 14

1. Options on commodities subject to the 1936 Act. 14

2. Options on commodities not subject to the 1936 Act. 16

3. Reintroduction of exchange-traded options. 18

4. Retention of ban on off-exchange options on enumerated commodities. 19

IV. RECENT DEVELOPMENTS IN AGRICULTURE EXPAND THE NEED FOR, AND THE USE OF, RISK-SHIFTING STRATEGIES. 23

A. Changes in U.S. government farm programs. 23

B. Changes in international markets. 26

C. The use of risk-shifting instruments in agriculture will continue to expand to address these changes. 27

1. Use of risk-shifting strategies by producers. 27

2. New risk-management instruments. 29

V. BENEFITS OF OFF-EXCHANGE AGRICULTURAL TRADE OPTIONS. 33

A. General characteristics of options. 33

B. Greater variety, supply and competition in offering options. 34

C. Trade options can permit greater precision of hedges and financing alternatives. 35

1. Customization leads to more efficient hedging. 35

2. Competition leads to market completion. 38

VI. RISKS OF TRADE OPTIONS. 39

A. Increased risk of fraud. 39

B. Credit risk. 43

C. Liquidity risk. 45

D. Operational risk. 46

E. Systemic risk. 48

F. Legal risk. 49

VII. POSSIBLE REGULATORY RESTRICTIONS TO ADDRESS POTENTIAL RISKS. 51

A. Nature of the parties. 52

1. Proxy limitations. 52

2. Registration, notification or line of business requirement for option vendors. 54

3. Education requirement. 57

B. Restrictions on the instruments or their use. 59

1. Basic characteristics associated with the "solely for purposes related to its business as such" requirement. 60

2. Restrictions to assure compliance with other legal requirements. 64

C. Regulation of marketing. 65

D. Other possible limitations. 68

1. Required cover of market risk. 68

2. Internal controls requirement. 70

VIII. RELATED ISSUES. 73

A. Issues relating to forward contracts having option-like features. 73

B. Clarification of swaps definition. 80

C. Comparability of treatment for exchange-traded markets. 82

IX. RECOMMENDATIONS. 85

A. Deny the petition to adopt as final the agricultural trade option rules proposed in 1991. 85

B. Consider lifting the agricultural trade option prohibition subject to appropriate conditions. 86

C. Publish in the Federal Register an Advance Notice of Proposed Rulemaking. 87

D. Confirm that the prohibition on agricultural trade options does not limit the scope of the swaps exemption. 88

E. Update and reissue the 1985 OGC interpretation on agricultural forward contracts. 89

POLICY ALTERNATIVES RELATING TO

AGRICULTURAL TRADE OPTIONS AND OTHER

AGRICULTURAL RISK-SHIFTING CONTRACTS

I. SCOPE OF THIS ANALYSIS.

Generally, the offer or sale of commodity options is prohibited except on designated contract markets. 17 C.F.R. 32.11. One of several specified exceptions to the general prohibition on off-exchange options is for "trade options." Trade options are defined as off-exchange options "offered by a person having a reasonable basis to believe that the option is offered to" the categories of commercial users specified in the rule, where such commercial user "is offered or enters into the transaction solely for purposes related to its business as such."⁽¹⁾ Trade options, however, are not permitted on the agricultural commodities which are enumerated in the Commodity Exchange Act, 7 U.S.C. 1 et seq. (Act).⁽²⁾

The Commission has considered several times whether to remove this prohibition on the offer and sale of trade options on the enumerated commodities. Industry views have been divided on the advisability of taking this action. The Commission began its most recent consideration of this issue by convening a public roundtable to discuss this issue. See, Transcript of the Chairman's Roundtable on the Prohibition of Agricultural Options, December 19, 1995 (December Roundtable). Subsequently, the Commission directed the staff to analyze agricultural trade option issues and to report on its findings. This analysis of policy alternatives responds to that directive.

The issue of whether to lift the prohibition on agricultural trade options is not the only issue that has been under discussion recently in relation to the changing nature of risk-shifting needs in agriculture. Trade options are only one of a variety of instruments under discussion. Care must be taken to distinguish whether the instrument being discussed is, in fact, a trade option or whether it is some other type of instrument. In this regard, lifting the ban on trade options for the enumerated agricultural commodities will not necessarily address the legality of other types of transactions or instruments.

Accordingly, this analysis, when referring to "trade options," refers only to commodity options, which are limited-risk, risk-shifting instruments. It does not include contracts that have both an option-like pricing mechanism and a merchandising component, such as minimum price guaranteed forward contracts. That type of contract is analyzed separately and distinguished from trade options throughout the analysis.

In addition, a separate rule of the Commission exempts swap agreements from most of the provisions of the Commodity Exchange Act and Commission rules, permitting them to be traded off-exchange. See, 17 C.F.R. Part 35. Issues relating to the applicability of the agricultural trade option prohibition to the swaps exemption are also analyzed. However, that exemption is applicable only to "eligible swap participants" and is not available to all commercials. In contrast, trade options for nonagricultural commodities may be offered to any commercial in connection with the commercial's business, regardless of size or other measures of sophistication. Accordingly, care should be taken to distinguish the differing eligibility requirements for these exemptions and the differences in risks and resulting need for customer protections associated with each.

Finally, the impact of lifting the agricultural trade option prohibition on the regulatory scheme for exchange-traded agricultural options is examined. Relevant issues include the potential effects on exchange markets from this action and the competitive implications of such changes to the regulatory schemes.

II. ANALYSIS OF THE ECONOMIC FUNCTIONS OF RISK-MANAGEMENT AND MERCHANDISING CONTRACTS.

Agricultural prices are subject to significant fluctuations. In order to hedge against this risk, merchandising contracts known as forward contracts were developed. From these contracts, exchange-traded futures and option contracts, which separated risk-management from merchandising functions, evolved. Both customized, off-exchange contracts and standardized, exchange-traded futures and option contracts offer benefits.

A. Price volatility and price risk in agricultural markets.

Agricultural prices are structurally prone to fluctuations because of the short-run inelasticities of supply and demand for agricultural products. Production of an agricultural commodity, for the most part, is fixed in the short run and is highly dependent on growing conditions, which can vary greatly from one year to the next. This can create periods of under or over supply. Similarly, the demand for basic commodities tends to be stable and generally is more responsive to changes in income and taste than to changes in price. In this situation, a small shift in supply or demand conditions can have a major impact on market prices. As a result of these price swings, farm incomes can be highly variable from one year to the next.

In addition, the supply of agricultural commodities within any one crop year or production cycle is seasonal in nature. Crops are abundant at harvest, and supplies fall during the remainder of the market year. Animal production, though more continuous, is also predisposed to production cycles due to animal birth rates and feeding schedules. Demand for most raw agricultural commodities, however, is steady throughout the year. This contrast can give rise to seasonal cycles of low prices at harvest or production peaks, followed by higher prices as stocks are drawn down.

Agricultural production and marketing includes the production of crops and livestock, and the marketing of this output to elevators, feedlots, and processors, who in turn market to wholesale and retail distributors. For example, a producer sells wheat to an elevator, which resells the wheat to a miller for grinding. The miller sells flour to a bakery which ultimately sells baked products to consumers. During the time necessary to produce a commodity and then to move it through these marketing channels, its value is subject to the price changes described above, creating price risk.

In response to this situation, both private market participants and government have undertaken measures to reduce or respond to price risk. Governments have set up programs to stabilize farm incomes through the use of buffer stocks, price floors and land set-asides to manage supply, and food programs for the poor to manage demand. The agricultural sector has developed various types of marketing arrangements and contractual agreements to shift this price risk to others. Beginning in the mid-1800s, forward contracts were developed as a means to secure buyers for grain. Since then, financial instruments, such as futures and options, have been developed to manage more efficiently the price risk inherent in the production and marketing of farm products.

B. The development of merchandising and risk management instruments.

In response to price volatility, risk management instruments were developed to offer buyers and sellers a hedge against price uncertainty. Initially, forward contracts combined risk shifting with merchandising features. Once trading in such contracts became established, futures and options contracts were developed to perform solely a risk-shifting function.

1. Development of marketing and risk-shifting contracts.

When only spot or cash markets existed for agricultural goods, producers would sell their crops or livestock at the prevailing market price whenever they were ready for sale. To protect against rising or falling prices in the spot market and to secure a buyer, contracts were developed establishing the terms for delivering product to a buyer in the future. These terms included the amount and grade of product, the time and destination of delivery, and price. Known as forward contracts, they combined a price-risk shifting function with a merchandising function, offering the advantage that a producer could know the price he would receive for his goods in advance of delivery.

Forward contracts had some weaknesses as risk-shifting instruments, however. For example, insofar as they were customized or dissimilar one from another, the contracts were difficult to resell or to reverse, making trading in forward contracts illiquid.

2. Development of separate risk-shifting contracts.

To address this disadvantage, parties began to trade standardized obligations to make or take delivery in the future. As a market formed in these contracts, speculators began to trade, thereby increasing liquidity. The demand for liquidity and ease in offsetting contract obligations over time led to trading rules and to formation of clearinghouses. These contracts thereby evolved into the futures and option contracts traded on exchanges today.

Futures and options appealed to market participants because they permitted agricultural producers and users to shift price risks to anyone willing to assume the opposite side of a trade without also having to use the contract to merchandize the commodity. Thus, as one observer noted, unlike futures contracts, forward contracts,

involved an eventual change of title to grain. When . . . [speculators] entered, this changed; . . . [they] did not intend to take or make delivery and as the forward contracts changed hands numerous times, a relatively small proportion of the participants intended to fulfill the contracts. The use of contracts for purposes other than exchange of title is one of the key differences between forward and futures contracts.
Hieronymus, Economics of Futures Trading, 76.

Trading such pure risk-shifting contracts on an exchange had many advantages. The exchange market was, and still is, characterized by high liquidity, low transactions costs and low risk of contract nonperformance. These benefits derived primarily from contract standardization and the performance guarantee provided by the clearinghouse. Standardization enhanced liquidity by concentrating trading volume in a limited number of uniform contracts. This lowered transaction costs by lessening information search costs and encouraging a finite pool of traders to compete in making a market in the contracts. Standardization also enabled multilateral offset of these contracts, because by novation the clearing organization became the buyer to every seller and vice versa. By clearing trades and requiring the posting of performance margins, contract performance was backed by the strength of the entire clearinghouse, instead of by the individual counterparty's creditworthiness.

A wider benefit of the exchange trading system was price transparency. Parties entering into exchange-traded futures or option contracts had immediate access to current, market-determined contract prices. This was in contrast to directly negotiated contracts traded off-exchange where there may have been significant inequalities in the pricing and other information available to the parties.

Despite the benefits offered by exchange-traded futures contracts, forward contracting continued, because it, too, offered particular benefits. In addition to their merchandising function, forward contracts--like other privately negotiated off-exchange contracts--could be customized to match more precisely the individual needs of the counterparties. This included the size of production, time and exact location of delivery and the exact grade of crop or livestock. These customized features could be used to reduce basis risk or to achieve greater hedging efficiency.

III. THE REGULATORY ENVIRONMENT.

A. Comparison of regulation of futures and forwards.

Despite the evolution of futures contracts from earlier forms of forward contracting, the regulatory scheme distinguished between the two in response to differences in the characteristics and uses of the instruments.

The growth of exchange-traded futures contracts was accompanied by glaring abuses such as price manipulations, market corners and extreme and sudden price fluctuations on the organized exchanges and, contemporaneously, the growth of off-exchange bucket shops. These abuses in turn stirred repeated demands from farmers and others for legislative action to prohibit or severely restrict futures trading.⁽³⁾ The pattern established from the earliest federal statute that comprehensively regulated futures trading in grain--the Futures Trading Act of 1921 (1921 Act),⁽⁴⁾--was to require all futures contracts to be traded on an exchange,⁽⁵⁾ which itself was subject to certain regulatory conditions.⁽⁶⁾ This pattern was continued and embellished through all subsequent amendments to the Commodity Exchange Act until 1992. At that time, Section 4(c) of the Act gave the Commission authority to exempt certain categories of eligible entities from various of the Act's provisions--including the exchange-trading requirement--for instruments which are, or may be, included under the Act.⁽⁷⁾

Forward contracts, however, were exempt from such regulation. In considering the scope of the bill which eventually became the 1921 Act, witnesses testified that there were a variety of legitimate transactions between commercials in the grain trade that were traded both on and off exchanges which could also fall within the phrase "contract for future delivery" of grain.⁽⁸⁾ These contracts were characterized by the fact that they were entered into between commercials (such as producers and merchandisers) and required, absent force majeure, or some other similar rare exception, the actual delivery of the grain in the future in normal cash marketing channels. To illustrate the merchandising nature of this type of contract, witnesses cited contracts with cooperatives for fall delivery of crops which had not yet been planted, certain types of export agreements for grain, and the sale of cash grain "actually in existence, in which there is 30, 60, or 90 day paper."⁽⁹⁾

Based upon this testimony, Congress excluded "contracts for deferred shipment or delivery" (forward contracts) from the definition of "contract for future delivery" (futures contracts) and, accordingly, from regulation under the Act. The forward contract exclusion was incorporated, unchanged, into the Grain Futures Act of 1922,⁽¹⁰⁾ the Commodity Exchange Act as originally adopted in 1936 (1936 Act), and the Commodity Exchange Act as amended in 1974, 7 U.S.C. 1 et seq. (Act).

B. The regulation of commodity options has a complex history.

The history of the regulation of commodity option trading is complex. At times, commodity options have traded legally on and off exchanges. At other times, trading has been prohibited. At times, regulatory treatment of options has differed depending on the underlying commodity.

1. Options on commodities subject to the 1936 Act.

The history of trading in, and the statutory scheme for the regulation of, commodity options is somewhat different from and more complex than futures. As early as 1874, the State of Illinois prohibited trading in privileges.⁽¹¹⁾ In response, the Chicago Board of Trade (CBT) initiated trading in an instrument denominated as an "indemnity of sale or purchase." This option-type instrument expired at the close of trading on the day following its creation.⁽¹²⁾

In 1936, responding to a history of large price movements and disruptions in the futures markets attributed to speculative trading in options, Congress completely prohibited the offer or sale of option contracts both on and off exchange in all commodities then under regulation.⁽¹³⁾ Over the years, this statutory bar continued to apply only to the commodities regulated under the 1936 Act. The specific agricultural commodities regulated under the 1936 Act included, among others, grains, cotton, butter, eggs and potatoes. Later, fats and oils, soybeans and livestock, as well as others, were added to the list. Together, they are referred to as the "enumerated" agricultural commodities. Any commodity not so enumerated, whether agricultural or not, was not subject to regulation. Thus, options on such non-enumerated commodities were unaffected by the prohibition.⁽¹⁴⁾

2. Options on commodities not subject to the 1936 Act.

In the years following passage of the 1936 Act, the off-exchange offer and sale of commodity options on the non-enumerated commodities was subject to fraud, abuse and sharp practice. That history was one of the catalysts leading to enactment of the Commodity Futures Trading Commission Act of 1974 (1974 Act), which substantially strengthened the Commodity Exchange Act and broadened its scope. The Act's scope was broadened by bringing all commodities under regulation for the first time. Congress accomplished this by adding to the list of enumerated commodities an expansive catchall definition of "commodity" which included all "services, rights or interests in which contracts for future delivery are presently or in the future dealt in."⁽¹⁵⁾

Under the 1974 amendments, the newly created Commodity Futures Trading Commission (CFTC) was vested with plenary authority to regulate the offer and sale of commodity options on the previously unregulated, non-enumerated commodities.⁽¹⁶⁾ The Act's statutory prohibition on the offer and sale of options on the enumerated agricultural commodities was retained.

Shortly after its creation, the Commission promulgated a comprehensive regulatory framework applicable to off-exchange commodity option transactions in the non-enumerated commodities.⁽¹⁷⁾ This comprehensive framework exempted "trade options" from most of its provisions.⁽¹⁸⁾ Trade options on non-enumerated commodities are exempt from all of the requirements applicable to off-exchange commodity options except for a rule prohibiting fraud (Rule 32.8) and a rule prohibiting manipulation (Rule 32.9).

In contrast to the regulatory framework for commodity options on the non-enumerated commodities, commodity options on the enumerated commodities--the domestic agricultural commodities listed in the Act--were prohibited both as a consequence of the continuing statutory bar as well as Commission rule 32.2, 17 C.F.R. 32.2. This prohibition made no exceptions and applied equally to trade options.

The attempt to create a regulatory framework to govern the offer and sale of off-exchange commodity options was unsuccessful. Because of continuing, persistent and widespread abuse and fraud in their offer and sale, the Commission in 1978 suspended all trading in commodity options, except for trade options.⁽¹⁹⁾ Congress later codified the Commission's options ban, establishing a general prohibition against commodity option transactions other than trade and dealer options.^(20)(21)

3. Reintroduction of exchange-traded options.

The Commission subsequently permitted the introduction of exchange-traded options on the non-enumerated commodities by means of a three-year pilot program.⁽²²⁾ Based on that successful experience, Congress, in the Futures Trading Act of 1982, eliminated the statutory bar to transactions in options on the enumerated commodities, permitting the Commission to establish a similar pilot program to reintroduce exchange-traded options on those agricultural commodities.⁽²³⁾

4. Retention of ban on off-exchange options on enumerated commodities.

In 1984 the Commission permitted exchange trading of options on the enumerated commodities under essentially the same rules that were already applicable to options on all other commodities.⁽²⁴⁾ In proposing these rules, the Commission noted that section 4c(c) of the Act and Commission Rule 32.4 permitted trade options on the non-enumerated commodities and that "there may be possible benefits to commercials and to producers from the trading of these `trade' options in domestic agricultural commodities."⁽²⁵⁾ However, "in light of the lack of recent experience with agricultural options and because the trading of exchange-traded options is subject to more comprehensive oversight," the Commission concluded that "proceeding in a gradual fashion by initially permitting only exchange-traded agricultural options" was the prudent course.⁽²⁶⁾ Nevertheless, the Commission requested comment from the public concerning the advisability of permitting trade options between commercials on domestic agricultural commodities. Citing past abuses associated with off-exchange options, the consensus among commentors was that the Commission should proceed cautiously and retain the prohibition on such off-exchange transactions.

In 1985, the Office of the General Counsel issued an interpretative letter providing advice regarding the legality of certain types of forward contracts containing option-like features. In that interpretation, discussed in greater detail below, the General Counsel reaffirmed that the ban on trade options on the enumerated agricultural commodities remained in effect. The general counsel opined, however, that bona fide forward contracts, which are excluded from regulation under the Act, could, under certain conditions, include some types of option-like pricing features, such as the inclusion in a forward contract of a guaranteed minimum price. This interpretation permitted producers to obtain certain of the benefits of agricultural trade options through a bona fide forward contract, for a time lessening debate over the issue.

Since then, the Commission has reconsidered the issue of whether to remove the prohibition on the offer and sale of trade options on the enumerated commodities several times. It also has been the subject of several meetings of the Commission's Agricultural Advisory Committee. Industry views were divided each time the issue was reconsidered. Many noted the potential benefits that agricultural options might offer to producers. Others expressed concerns over possible fraudulent activity and suggested that such contracts might result in confusion regarding the obligation to deliver on cash contracts. The Commission's most recent action with respect to this issue was in 1991, when it proposed deleting the prohibition on trade options on the enumerated commodities and including them under the same exemption applicable to all other commodities. 56 F.R. 43560 (September 3, 1991). The Commission never promulgated the proposed deletion as a final rule.

On December 19, 1995, the Commission hosted a public roundtable to consider this issue once again and to provide a forum for members of the public to provide their views. Seventeen members of the public participated, representing a broad cross-section of agricultural interests as well as academia and the futures industry. In addition, written comments were accepted and incorporated into the record. Some still expressed reservations over the wisdom of lifting the prohibition. In general, however, based upon a perception that those engaged in agriculture today have a greater need for risk-shifting instruments, roundtable participants expressed varying levels of support for relaxing the prohibition. The Commission directed the staff to study the issue and to report on its findings.

By letter dated January 30, 1997, the National Grain and Feed Association (NGFA) petitioned the Commission to repeal immediately the prohibition on agricultural trade options in its entirety. NGFA's petition advocated that the Commission proceed to promulgate final rules on the basis of the 1991 Notice of Proposed Rulemaking, noting that lifting the ban on agricultural trade options, "would put agriculture on an equivalent footing with other commodities that have been exempt from such a ban for years. . . ." January 30, 1997, letter, p. 4.

IV. RECENT DEVELOPMENTS IN AGRICULTURE EXPAND THE NEED FOR, AND THE USE OF, RISK-SHIFTING STRATEGIES.

Agricultural markets in the U.S. are undergoing profound changes. These changes increase uncertainty in agricultural markets and expand the need for risk-shifting strategies.

A. Changes in U.S. government farm programs.

Crop deficiency payments, which previously played a major role in stabilizing farm incomes, have been eliminated along with planting restrictions.

The federal government historically has used a variety of methods and programs to support farm incomes and manage the supply of food and fiber. These programs can be classified into three general categories: storage loans, government purchase and disposal programs and direct farm income supplements.⁽²⁷⁾ Specific programs have included acreage set-aside programs, export subsidies, supply control, management of stocks and the use of nonrecourse crop loans to set price floors. In addition, deficiency payments--based on the difference between target and market prices--were used to help assure farm profitability.

The Federal Agricultural Improvement and Reform Act of 1996 (FAIR Act) removes the link between federal government income support payments and farm prices. A major provision of the FAIR Act replaces deficiency payments with seven-year, fixed-payment contracts called "production flexibility contracts." Payments on these contracts will not be adjusted according to changes in agricultural prices. Instead, the legislation sets a declining national total payment to be divided proportionally among participating farms.

In addition, land use restrictions will be lifted to allow greater flexibility as to how much land and which crop may be cultivated. The annual acreage restriction program, which is designed to manage output and conserve soil and which idled over 10% of cropland in some years,⁽²⁸⁾ will be eliminated. Only conservation and wetlands protection programs will remain. Moreover, producers will no longer be required to buy a minimum level of crop insurance although, if they decline insurance, they waive eligibility for emergency crop-loss assistance.

While the government safety net for farmers is shrinking, some government involvement in agricultural programs will remain. For instance, the nonrecourse marketing assistance loan program remains. In the past, this program often was used to set a floor price for crops by allowing producers' to surrender their crop as full repayment for loans. The revised program, however, is designed to minimize the potential for producers surrendering commodities to the government. Specifically, loan rates generally will be set at 85% of the preceding five-year Olympic average (which drops the high and low prices from the calculation of the average). Loan rates for grain crops also can be reduced if stocks begin to accumulate. The revised program also provides that, in order to reduce the amount of grain surrendered under the program, producers may be permitted to repay less than the full amount of the loans if, among other things, the Secretary of Agriculture determines that such an action will allow crops freely to be sold domestically and internationally.

The government also will continue to dispose of surplus commodities through a variety of programs. The most well known of these programs, which began in 1954, is P.L. 480, also known as "food for peace." Although these programs usually target underdeveloped or developing nations for humanitarian purposes, they also serve to reduce surplus inventories.

The overall impact of the 1996 FAIR Act will be to leave farm incomes more exposed to changes in market prices. In addition, greater planting flexibility and fewer acreage restrictions may create greater variation in production, leading to greater price volatility.

B. Changes in international markets.

Changes in international markets will have an uncertain impact on U.S. agriculture.

The rules governing international trade, including those applicable to agricultural goods, have been revised significantly over the past five years. Large free trade zones have been formed in Europe and North America. These agreements are predicated, in part, on the reduction of agricultural supports and subsidies within the zones. For example, the North American Free Trade Agreement went into effect on January 1, 1994, lowering U.S., Canadian and Mexican tariffs.⁽²⁹⁾ Similarly, a worldwide renegotiation of the General Agreement on Tariffs and Trade has lowered barriers to international trade in agricultural products and reduced subsidies and support programs across many nations.⁽³⁰⁾ The eventual impact on U.S. agricultural markets of these steps towards global free trade is uncertain because, in a free market environment, countries likely will reallocate production resources according to their individual comparative advantages.⁽³¹⁾

C. The use of risk-shifting instruments in agriculture will continue to expand to address these changes.

1. Use of risk-shifting strategies by producers.

Few studies or surveys detailing the use of risk management tools by agricultural producers have been published. One such study by Kansas State University, however, finds that the percentage of Kansas farmers hedging their crops has risen substantially over time. The use of forward contracts has increased from 12% in 1972 to 18% in 1983 to 45% by 1992. For the same years, the use of futures contracts has increased from 4% to 7% to 11%, respectively. Although the ban on exchange-traded commodity options was not lifted until 1984, the survey indicated that 19% of Kansas farmers were using such options by 1992.⁽³²⁾ A second study reporting on surveys of Kansas grain farmers, conducted between 1988 and 1992, indicates a strong preference among these producers for forward contracts over the use of futures or option contracts.⁽³³⁾

In addition, the USDA's 1994 Farm Cost and Return Survey (FCRS)⁽³⁴⁾ contains some nationwide information regarding the perceived importance of forward, futures or option contracts. Among farms with more than $50,000 in gross sales, reducing variability of prices by using forward contracts or hedging instruments was deemed "very important" by only 30% to 39% of respondents. The survey also indicated that the actual use of various contracts differed according to type of commodity produced and farm size.

The volume of exchange-traded options on agricultural commodities has grown in recent years. For example, the CBT reports that the growth in volume of agricultural options traded during 1996 was 68%.

2. New risk-management instruments.

In response to greater demand, new risk management tools are being developed, a trend which is likely to continue. Among these are new forms of federally subsidized crop revenue insurance, exchange-traded futures and options on crop yields, and certain types of cash forward contracts.⁽³⁵⁾

Although federal catastrophic crop insurance has been in existence for most program crops since 1980 (and for some crops since the 1930s), two new insurance products were developed over the past few years. Income Protection (IP) policies insure farmers against a fall in revenue or gross income. Farmers can buy federally subsidized insurance to cover 50% to 75% of their expected yield (based on the farmer's historic yield) times the expected price at harvest. Thus, the farmer's income is protected if either prices or yields fall. The Crop Revenue Coverage (CRC) insurance program includes income protection like IP insurance and also contains a "replacement coverage" provision. That provision indemnifies the producer at a rate equal to the higher of the original insured price or 95% of the cash price at harvest. Thus, if at harvest crop prices are higher but yields are lower than the insured amounts, the indemnity is calculated by multiplying the insured yield by 95% of the cash price, rather than the original price.

Innovations have also occurred in cash merchandising contracts. One such contract is the hedge-to-arrive (HTA) contract.⁽³⁶⁾ Early versions of HTAs enabled producers to set the futures price for delivery while allowing the basis⁽³⁷⁾ to be set at a later date. This differed from a classic forward contract which required producers to set the basis at contract initiation. Once the producer locked in the basis, the HTA contract operated just like a conventional forward contract, having a fixed price and delivery date.

Innovation in the types of instruments available to the agricultural sector likely will continue. In the financial markets for debt and securities, as well as in the markets for commodities like petroleum products and metals, financial engineers have created a large array of derivatives contracts that can be used to manage price risk. This growth can be attributed not only to the need to shift risks, but to the 1972 development by Fischer Black and Myron Scholes, of a model to price options.⁽³⁸⁾ The Black-Scholes model and those which followed were an important breakthrough because they permitted more accurate pricing of such instruments, enabling greater efficiency in risk management programs.

Against the background of increasing risk and uncertainty, greater interest by some segments of the agricultural sector in managing risks and the development of more sophisticated models of risk management products, the Commission must determine whether the prohibition on the offer or sale of off-exchange agricultural trade options should remain in effect or be removed, either with or without conditions.

V. BENEFITS OF OFF-EXCHANGE AGRICULTURAL TRADE OPTIONS.

Off-exchange options enable hedgers and risk managers to customize the terms of the contract better to meet particular needs. Lifting the ban on agricultural trade options potentially increases the supply of, and the competition in offering, agricultural options.

A. General characteristics of options.

Option contracts give hedgers a unique risk-management tool with a known cost.

Options provide a highly effective tool for hedging and have unique pay-out characteristics. Options differ from futures contracts in that they are a limited price-risk instrument. That is, the purchaser of an option contract can profit from a price rise (in the case of a call) or price fall (in the case of a put), but limit any losses on the contract to the price of the premium paid for the contract.

Options can be used to construct a hedge that protects against adverse price risk while leaving open the potential for higher profits. Of course, this profit potential has a cost--the premium that must be paid to obtain the option. The purchaser of an option knows from the outset the amount of the premium however payment is structured. Thus, the hedger knows the maximum cost of the hedge and is not confronted with margin calls of unknown magnitude if prices move adversely. In addition to these benefits, which are associated with options generally, off-exchange trade options allow hedgers and risk managers to obtain the additional benefits discussed below.

B. Greater variety, supply and competition in offering options.

Lifting the ban on agricultural trade options may result in more competition in the offering of options on these commodities and provide greater convenience for producers by permitting a variety of option vendors. The added source of vendors may reduce various costs to option users of obtaining information relating to their market decisions.

A major benefit of trade options is the potential for a greater supply of, and competition in offering, option contracts. Currently, only standardized, exchange-traded options are available for agricultural product hedging. Presumably, lifting the ban would encourage competition between customized contracts and financing arrangements offered by various off-exchange counterparties and the more standardized but highly liquid, low credit-risk products offered by exchanges.

Moreover, lifting the ban would permit a greater variety of option vendors, which could reduce the informational search costs to certain hedgers. Hedging can be a complex matter involving knowledge by the hedger of his market position, delivery timing, quantities and qualities of commodity production, inventory, financial wherewithal and marketing objectives. In addition, a hedger must be cognizant of risks associated with the counterparty on the cash commodity, particularly default risk.

To reduce search costs, many hedgers may choose to rely on established cash market trading channels to gather information on contracting methods. Established cash trading partners may have a greater understanding of the hedger's marketing position and needs than others. These cash trading partners may, therefore, be better situated to recommend particular hedge strategies and contracts. In addition, ongoing business relationships with these parties may have instilled a level of trust between counterparties, allowing hedgers to make informed assessments as to credit risk and possibly to use cash market obligations as collateral for trade option positions.

C. Trade options can permit greater precision of hedges and financing alternatives.

Customized option contracts permit more precise matching of hedges to amount, timing and other commodity characteristics. Buyers of trade options may be able to finance the purchase through an arrangement with the seller. The availability of customized trade options also moves the markets toward market completion.

1. Customization leads to more efficient hedging.

a. Customization of contracts. In competing to offer option contracts, option vendors may offer customers a greater variety of desired attributes or services. For example, futures commission merchants (FCMs) can compete by offering exchange-traded options which offer a high degree of liquidity and low credit risk. They may also offer trade options, to the extent permissible, that have features currently unavailable on any exchange, such as average-price options.⁽³⁹⁾ Elevators and other first-handlers, on the other hand, presumably may offer option contracts having terms or financing arrangements more closely tailored to the hedging or other needs of the customer. Through such competition, a hedger may have a greater number of alternatives from which to choose in deciding which contract source best suits his or her hedging needs, balanced against his or her tolerance for credit risk.

The potentially greater array of contracts and services may enable hedgers to achieve more precise hedging in a variety of ways. For example, more efficient hedges may be attained by more closely matching the size of the option contract to the underlying cash market position. The standard size of exchange-traded option contracts may not correspond to the spot or forward obligations of a hedger. If the contract size is not a multiple of a producers's output, the hedger is forced to under- or over-hedge.⁽⁴⁰⁾

Trade options also allow a hedger to specify expiration or delivery dates to coincide more closely with harvest dates, processing schedules or the timing of forward contracts. This reduces a hedger's exposure to the risk from mismatching the expiration date of an exchange-traded contract. Basis risk also can be reduced for the hedger by allowing a closer match to the grade of crop or livestock at a particular delivery location.

In addition to tailoring contracts to match more closely the underlying commodity, customers, through the bundling of various options, can also gain access to contracts which hedge multiple risks. Producers, for example, face production risks and price risk associated with inputs and outputs. Currently, a producer can hedge these risks separately by purchasing, to the extent that they exist, separate options on the inputs and outputs and either purchasing crop insurance or possibly an option on crop yield futures. However, a counterparty might be able to offer at a lower price a single trade option contract that hedges all of these risks.⁽⁴¹⁾

b. Flexibility of financing. Trade option contracts also may address the need for sufficient cash flow to maintain margins on open futures contracts or to prepay option premiums. Although trade options typically are not margined, depending on the terms of the contract, they may allow the option purchaser to delay payment of the premium. In certain cases the option may be collateralized implicitly by linking the option and a contract to deliver the crop or livestock to the same counterparty. The premium can then be incorporated into the cash contract by deducting it from the final price of the commodity at delivery.

2. Competition leads to market completion.

A complete market is one which has a sufficient variety of instruments to enable individuals to obtain any degree of risk allocation. Exchange-traded futures and particularly option contracts are extremely effective tools in moving markets toward completion because of the variety of payouts that can be constructed from them. However, even though these instruments may significantly contribute to market completion, they still may not enable individuals to obtain their most preferred allocation of risks. That is, without the customization that is available with trade options, certain market risks may remain. Competition would encourage offerors to develop customized trade options that address these risks, thereby moving the markets closer to completion.

VI. RISKS OF TRADE OPTIONS.

While trade options offer many of the same economic benefits that are offered through exchange-traded options, the markets differ markedly in terms of protections and how contracts are traded. In evaluating trade options, six sources of risk cause heightened concern: fraud, credit risk, liquidity risk, operational risk, systemic risk and legal risk.

A. Increased risk of fraud.

Trade options on the enumerated commodities, as with all commodity-related over-the-counter instruments, would trade in a less-regulated environment than exchange-traded options. The Act imposes legal requirements on an exchange, mandating that it police itself and its participants for illicit activity. In addition, the regulatory structure imposes a variety of prophylactic protections against egregious forms of fraudulent and abusive conduct. When trading is conducted on a centralized market with standardized trading instruments and procedures, it is possible for the government to offer a broad level of customer and market protection by applying relatively modest levels of its resources.

In contrast, much of the appeal of trade options stems from the desire to deal with known counterparties or to customize the contracts. However, regulatory oversight and enforcement is limited in such circumstances to the extent that vendors of the instrument are not themselves regulated. Although the vendors in a decentralized market could be subject to a regulatory scheme, the absence of a centralized market and a self-regulatory organization reduces the effectiveness of any such regulatory protections. Because transactions in trade options would be decentralized, the resources necessary to surveil that activity would be far greater than those necessary to oversee the operations of a centralized market. Finally, the ability of the government to police such activity directly, without the assistance of a self-regulatory organization, would require a commitment of greater resources.

Customization of particular contracts also increases the possibility of fraud. The lack of standardization may make the oversight and policing of trade practices more difficult. Providing prophylactic protections, as well as establishing general rules of appropriate conduct, is more difficult when contract terms are not standardized. Moreover, where practices vary greatly from one vendor to another, enforcement is made more difficult.⁽⁴²⁾

Just as a lack of standardization may make it more difficult to police trading in these instruments, it may also make it more difficult for customers to protect themselves from fraudulent or wrongful practices. Initially, it is expected that agricultural producers and users would enter into put and call options that were very similar to those already offered on-exchange. However, to the extent that the terms of the contracts or financing arrangements for them became more complex, greater time will be required for individuals to become familiar with a particular product. Moreover, individuals will by necessity progress through a learning curve as they become familiar with a particular product and how it interacts with their set of circumstances. During the early stages of this process, individuals may be more susceptible to fraudulent activity. This, and the possible variation among instruments from one source to another and the time it takes to familiarize oneself with each new or different product, increase the chance that certain individuals will exploit the opportunity to commit fraud.⁽⁴³⁾ Of course, educational efforts aimed at potential participants in such instruments might, to some degree, ameliorate these effects. Conversely, this problem may be exacerbated to the extent that the fraudulent activity is carried out through the guise of providing education on these instruments.⁽⁴⁴⁾

In such a decentralized market, participants find it more difficult to detect possible fraudulent conduct by their counterparty. The lack of transparent prices may make it difficult for parties to accurately ascertain a reasonable value for the contract. Moreover, to the extent that there is a lack of daily marking of positions to market or reporting of account position statements, as a matter of practice or regulatory requirement, it may make it more difficult for a counterparty to uncover possible fraudulent activity. These weaknesses may exacerbate other information inequalities and create a climate where fraudulent or sharp practices are made easier.

Finally, certain counterparties, particularly those who are also Commission registrants, could have conflicts of interest and customers may be confused as to the role of the counterparty. For example, to the extent that FCMs are permitted to offer trade options as principals, but also to act as fiduciaries in relation to executing exchange-traded options, confusion on the part of the customer may result as to the FCM's role and responsibilities. Of course, where the counterparty is a Commission registrant, the potential conflicts could be addressed through required disclosures or other mechanisms.

In the past, the Commission has found fraud in connection with the offer and sale of off-exchange options contracts to be a serious problem. In 1978 the Commission adopted a rule that suspended the offer and sale of commodity options to the general public.⁽⁴⁵⁾ In adopting the rule, the Commission noted that "[t]he Commission's experience to date indicates that the offer and sale of commodity options has for some time been and remains permeated with fraud and other illegal or unsound practices notwithstanding a substantial investment of the Commission's resources in attempting to regulate rather than prohibit option trading." The Commission also expressed its view that the absence of exchange trading in the U.S. at that time may have contributed to problems with option trading.

B. Credit risk.

Credit risk is the risk that a counterparty will be unable to perform on an obligation. Credit risk is present in every transaction between the time a contract is entered into and the delivery date, although it changes over time based on changes in market conditions. Even though measures can be taken to reduce credit risk, these measures have a cost, and counterparties may choose not to implement them or may lack sufficient bargaining power or sophistication to require them. Such measures might include the posting of collateral, credit analysis, letters of credit or other guarantees.

In the case of an option, where a purchaser pays the premium up-front, the credit risks faced by the purchaser and the writer differ. The writer of an option faces significant market exposure, such that the writer's out-of-pocket losses may exceed the premium paid by the purchaser. Thus, the purchaser is at risk that the writer will not perform. The writer of an option typically does not face credit risk, however, because, unless the premium is financed or deferred, the purchaser has already performed on the contract by paying the premium.⁽⁴⁶⁾ An option purchaser, therefore, must take particular care to assure himself or herself that the option writer is able and will be willing to perform on the contract under all market conditions.

C. Liquidity risk.

Liquidity describes the ability to execute a transaction quickly at a low cost. As with most privately negotiated contracts, holders of trade options face a high degree of liquidity risk.

A hallmark of exchange trading is the concentration of liquidity. Liquidity enables customers quickly to enter into a transaction without significantly raising or lowering the purchase or sale price in the process. For example, consecutive transactions in exchange-traded options typically differ by only a fraction of a cent per bushel. This indicates that a customer can expect to enter into a trade at approximately the same price as the previous price.⁽⁴⁷⁾ Moreover, under normal conditions that trade could take place at any time the markets are open.

The market for trade options differs markedly in liquidity from exchange markets. Exchange markets permit trading among a diverse group of participants. Moreover, contracts are standardized and fungible, allowing any contract to be traded with any participant. The potential pool of participants for a specific trade option is much more limited. An individual entering into a trade option will likely have only a handful of offerors from which to choose. In addition, because trade options are typically not fungible, once one is entered into, the holder of the option can exit only by returning to the offeror. This may result in a higher cost to the hedger than would be the case with a more liquid, exchange-traded instrument.

D. Operational risk.

Operational risk relates to the ability to monitor and maintain control over an enterprise. Specifically, this risk relates to the ability to understand the terms of a contract, to monitor its market value, to assess how the contract interacts with other areas of the enterprise at any particular time, and to respond quickly to changes in the marketplace.

The ability to monitor and control various aspects of the operation is an important consideration for any successful enterprise. Operational risk is the risk that the monitoring and control of operations cannot be sufficiently maintained and that financial losses occur as a result. The operational risks associated with off-exchange products may be higher than for exchange-traded contracts.

Exchange-traded contracts are highly standardized. As a result, the terms and conditions of the contracts and the environment in which they are traded are well understood. In addition, familiarity with these contracts has become highly developed over the years. Familiarity with exchange-traded options tends to reduce the operational risk associated with their use. This risk is further reduced because of exchange and CFTC disclosure rules and other requirements, including daily marking-to-market of positions and regular customer position statements, which keep individuals informed of accruing losses.

In contrast, trade options are not traded in a transparent environment or on a continuous basis. As a result, prices may not regularly be reported, and positions may not be marked to market on a regular basis. Thus, it may be more difficult to monitor the market value of a position,⁽⁴⁸⁾ thereby increasing the degree of operational risk.

It should also be noted that, in the case of agricultural trade options, the most likely counterparty to producers is the local country elevator. Adding option contracts, particularly those with unusual terms, to the marketing mix of contracts already offered by an elevator may increase the complexity of the elevator's overall position and make it more difficult to hedge. Thus, the elevator's operational risk related to the use of trade options may be higher than under the current situation.

E. Systemic risk.

Systemic risk, or the risk of widespread financial disruptions, may be particularly problematic in rural economies which tend to be isolated and are highly dependent on agriculture.

Generally, systemic risk is the risk of a broader collapse of entities or contracts that can be traced back to the collapse of an initial contract or group of contracts. A scenario describing systemic effects arising in connection with agricultural trade options could begin with an elevator which accumulates a significant trade option position. Suppose that the elevator has difficulty meeting its obligations on those contracts. Such difficulty may arise from a third party's not meeting its obligations to the elevator (default risk), the elevator's not adequately hedging or otherwise covering the position (market risk), a breakdown in internal controls related to the option position (operational or fraud risk) or some other problem. For whatever reason, problems related to the trade option position cause the elevator to default or delay its performance on the contracts. This nonperformance may then spread to the elevator's trade option counterparties, as well as to others. Some of these may be producers who also deal with the elevator or other entities inside and outside of the agricultural sector which have credit arrangements with, contracts with, or obligations to the defaulting elevator.

While the repercussions from a widespread default can be problematic wherever it occurs, they can be particularly troublesome in rural areas where the economies of a town or region can be relatively isolated and highly dependent on agriculture. Thus, a default relating to agriculture could potentially spread quickly to other sectors of the local or even regional economy.

F. Legal risk.

Enterprises which choose to operate under an exemption, such as the trade option exemption, must carefully conform their activities to fit within the terms of the exemption or risk finding that their conduct violates that or some other legal provision.

Lifting the ban on trade options on the enumerated commodities would provide an additional exemption from the general rule requiring commodity futures and option contracts to be traded only on designated contract markets. To the degree that the current prohibition is removed or relaxed, entities choosing to operate pursuant to that exemption would have to take care to conform their activities to the terms of the exemption. Failure to do so might expose such an entity to the legal risk that a particular over-the-counter derivative contract offered by it was not covered by the exemption and that its offer or sale violated either that exemption or some other provision of the Act or Commission rules.

The degree of risk of this occurring would depend upon the extent to which a simple option contract were modified. In a simple option position, the holder of the option has the right but not the obligation to make or take delivery of a commodity at a given price. However, as has been seen in the development of derivative contracts in the financial markets, this simple contract can evolve into more complicated instruments with payout structures significantly different from those associated with a simple option. These structures give rise to the risk that the resulting instrument comes more closely to resemble a futures contract, rather than an option contract. Accordingly, in order to avoid a violation, those offering options contracts in reliance on the trade option exemption would have to assure themselves that the instruments they offer adhere closely to the terms of that exemption.

VII. POSSIBLE REGULATORY RESTRICTIONS TO ADDRESS POTENTIAL RISKS.

As detailed above, removing the current ban on agricultural trade options potentially provides producers and users of agricultural commodities with a greater variety of risk-management tools. However, significant risks exist in removing this long-standing prohibition, particularly with regard to the increased possibility of fraud, liquidity risk, credit risk, systemic risk and operational risk in connection with the offer and sale of these instruments.

One approach to striking an appropriate balance would be to remove the prohibition subject to regulatory conditions. Some of the exemptions promulgated by the Commission in recent years which are applicable to off-exchange instruments, including the trade option exemption for nonagricultural commodities, have not imposed such regulatory requirements as a condition for the exemption.⁽⁴⁹⁾ However, relaxing the prohibition on trade options on the enumerated domestic agricultural commodities need not follow that pattern. Indeed, the trade option exemption is itself an exemption from a larger set of rules--now suspended--regulating the offer and sale of off-exchange commodity options.⁽⁵⁰⁾ See, 17 C.F.R. Part 32. A variety of regulatory protections or conditions could be fashioned to address many of the risks noted above.

A. Nature of the parties.

One means of addressing several of the risks noted above would be to restrict the availability of agricultural trade options to sophisticated individuals or entities, require that those selling these instruments be registered with, or identify themselves to, the Commission or be commercials themselves, and/or impose an education requirement on either or both buyers and vendors of the instruments.

1. Proxy limitations.

An indirect means of discouraging unsophisticated individuals from entering into trade options would be to use transaction size as a proxy for sophistication. A high minimum transaction size effectively would bar smaller, less well-capitalized--and presumably less sophisticated--commercials from participating. This approach has been a stipulated condition of transactions permitted under several Commission and staff no-action letters.⁽⁵¹⁾ Transaction size limitations are a clear, easily applied--albeit crude--means of measuring sophistication.⁽⁵²⁾ Similarly, the net worth of the customer counterparty could be used as proxy for determining sophistication.

Proxy limitations may be over- or under-inclusive. In the case of size restrictions, they may limit hedging flexibility. As mentioned above, many producers do not use exchange-traded contracts because they prefer not to post margin, do not have brokers to sell them exchange-traded options or must arrange financing for the position. Entering into a trade option contract with a local elevator may address these producer concerns. Using these proxy limitations, however, may make trade options unavailable to the smaller entities that might otherwise find them the most useful.

Conversely, such proxy limitations may also be a crude, though clear, means of distinguishing among entities when determining to which, if any, various conditions for lifting the ban on agricultural commodities should not apply. Because any regulatory restriction imposed should seek the least costly means of achieving the regulatory objective, some distinctions among market participants may be appropriate. For example, while certain conditions may make sense at the producer/first handler level, the same conditions might be unnecessary for participants at other levels of the processing chain.

2. Registration, notification or line of business requirement for option vendors.

Another method of limiting access to agricultural trade options as a means of maintaining regulatory oversight is to limit those entities or individuals which may become trade option vendors. For example, option vendors could be required to register in some capacity with the Commission as a condition of doing business.⁽⁵³⁾ Currently, there are several categories of individuals and entities that must register and comply with the rules and regulations of the Commission. Moreover, section 32.3 of the Commission's regulations, which applied to off-exchange options generally before their trading was suspended, made it unlawful for any person to offer an option contract unless such person was registered as an FCM under the Act.⁽⁵⁴⁾

Alternatively, the Commission could consider creating new requirements that would be applicable only to the offer and sale of agricultural trade options. Such requirements could establish a new category of special registration or could simply require that those offering such instruments identify themselves by notifying the Commission. Required registration would give the Commission the most direct means of regulating the behavior of market participants. Conditions of registration or permission to offer such instruments might include required proof of honesty, competence and financial capacity. In addition, any entity, offering or selling such instruments, whether or not a registration requirement is imposed, could be required to disclose risks, to cover the transactions and to provide account confirmation and verification information. Notification to the Commission by those undertaking to offer and sell agricultural trade options would, at a minimum, provide the Commission with a window into the extent of, and practices in, the market, and a means to expedite commencing investigations of alleged misconduct.

Although a registration requirement would give the Commission greater control over offerors of trade options, there are costs associated with this strategy. To the extent that conditions are placed on registration, costs may be incurred by those seeking registration. Depending on the nature of those conditions, the costs potentially could include expenditures incurred in preparing documents required to become registered, any registration fees required by the Commission and legal or auditing costs necessary to assure continued compliance with the requirements.

A registration requirement would also result in costs to the Commission. These costs would be related to the approval process for registrants, to any ongoing monitoring or auditing of registrants required to assure compliance with Commission rules and to any enforcement actions against registrants found to be in violation of such Commission registration rules.

In lieu of, or in combination with, required registration, the Commission could restrict vendors of trade options to commercial entities involved in the handling or use of the commodity. Part 32.4(a) of the Commission's rules currently requires only that the party being offered a trade option be a producer, processor, or commercial user of, or a merchant handling, the commodity which is the subject of the trade option. Placing a similar restriction on the offeror (vendor) of the option would exclude nonagricultural entities from these markets. Such a restriction would discourage the type of boiler room or fly-by-night operations which historically have been a problem associated with over-the-counter markets in commodity interests. On the other hand, such a restriction would reduce the overall supply of agricultural trade options by preventing otherwise acceptable counterparties, such as banks or insurance companies, from entering the market.

3. Education requirement.

As an alternative for, or in conjunction with, other requirements and restrictions, the Commission could institute an educational program or condition. Many of the participants in the December Roundtable expressed the concern that individuals need better education in the use of option contracts and in the principles of risk management generally.⁽⁵⁵⁾ The appeal of such a program rests on the assumption that better educated individuals can better protect their own interests, thereby reducing the need for other regulatory restrictions or monitoring procedures. This would also enable individuals to explore more freely alternative uses of trade options. In addition, better educated individuals would presumably make wiser use of trade options or other risk management tools.

Although the Commission currently does not have any educational requirements for individuals using futures or options contracts, the exchange-traded options pilot program established under the 1990 farm bill,⁽⁵⁶⁾ a program limited to a relatively limited number of counties, required persons participating in the program to complete educational training. Seminars on marketing and the use of exchange-traded options were developed by the USDA and presented through the State Cooperative Extension Service together with representatives from the State and County Consolidated Farm Service Agency. The instruction included an introduction to the Options Pilot Program and a review of options trading procedures.⁽⁵⁷⁾

Although an educational program or requirement has great appeal, implementing the program could be very costly, especially in light of its potential nationwide scope. Currently, the Commission has no ongoing program to educate the large number of individuals who might use trade options. The Commission, however, is engaged in discussions and planning with the USDA on a risk education program for farmers mandated by the FAIR Act. A trade option educational program or requirement could be linked with those efforts.

Mandatory attendance to fulfill an education requirement may not achieve the desired effect of raising the level of understanding or sophistication among potential participants, however. Unless competency also is tested, an attendance requirement alone may not be indicative of the actual sophistication of a participant and could lead to a false sense of security by the government, potential vendors, and the customers themselves, that those who met the education requirement were in fact knowledgeable or suitable customers.

However, the cost of developing and monitoring an on-going competency-based certification program could be high. An alternative means of addressing this cost would be to permit participants to receive training from appropriate private sector providers. Unless the instructional level of all such privately-offered seminars were mandated and verified, however, there would be little assurance of the consistency of their quality. In addition, to the extent that private providers or organizations undertook this role, there would be a risk that educational programs could resemble or become marketing seminars. Unsuspecting customers might even be lured to this type of marketing seminar under the guise of fulfilling such an educational requirement.

B. Restrictions on the instruments or their use.

Restrictions on the instruments might be considered as a means of ensuring that commercials enter into such transactions "solely for purposes related to [their] business as such."

Several restrictions, either direct or indirect, may be placed on the use of agricultural trade options, in addition to the requirement that they be offered only to commercial entities. Section 32.4 of the Commission's regulations requires that trade options be offered only to a commercial entity "solely for purposes related to its business as such." Although the Commission has not had occasion to address the scope of this restriction definitively, in considering lifting the ban on agricultural trade options, the Commission should make clear that this exemption is not without boundaries. Recent experience in the case of HTA contracts suggests that in some cases producers strayed, inadvertently or otherwise, from using those contracts to hedge or manage their business risks. This experience also suggests that, at least initially, the Commission should consider delineating, by either specific restrictions or more general guidance, those practices which in the context of agricultural trade options will ensure that the use of such options remains within the intent of the exemption.⁽⁵⁸⁾

1. Basic characteristics associated with the "solely for purposes related to its business as such" requirement.

For example, the requirement that trade options be for a business-related use suggests that the overall size of all agricultural trade option contracts and any other derivative positions should not exceed the size of the cash or forward market position being hedged. Under most circumstances, a position in a derivative contract that exceeds the size of the underlying cash or forward position increases price risk. While a fixed size restriction cannot be specified by regulation in advance, trade options could be conditioned upon the customer's position not exceeding the underlying cash position less any other commitments related to the commodity, including futures contracts, exchange-traded option contracts and forward contracts. Other requirements associated with managing risk, such as the existence of a predictable relationship between the crop produced and the commodity on which the option is written and the timing of option expiration and harvest of the commodity, should also be fulfilled. If these criteria are made conditions of the exemption, the vendor would be required to determine whether they have been met. In contrast, if these criteria are provided as guidance, this information could be made available through mandatory disclosure documents and/or a required educational program.

Where contracts are allowed to extend over multiple crop years or the delivery period can be changed, the Commission could require, or provide guidance, similar to the guidance offered by the Division of Economic Analysis related to HTA contracts, that the trade options expire in the appropriate crop year. For options extending over multiple crop years, the expiration dates of the options should coincide with the delivery periods for the underlying commodity. In the case of contracts that can be rolled, the rolling provisions should be limited to apply only to situations where rolling reflected the production and inventory-carrying nature of the underlying position.

Consideration should also be given to delineating if, or under what circumstances, the practice of a producer or other agricultural business selling options to generate premium income is "solely for purposes related to its business as such." While the purchaser of an option holds a limited risk instrument, option sellers potentially face unlimited price risk. The seller of a put option theoretically can lose the entire value of the strike price less the premium if the value of the underlying commodity falls to zero. The seller of a call faces unlimited price risk if he or she is forced to deliver a commodity whose price has risen far above the strike price of the option.

A practice sometimes used by individuals having positions in the underlying commodity is to enter into what is known as a covered position. For example, a producer enters a covered call position when he or she writes a call option that can be satisfied through delivery from production. In such a case the producer locks in a maximum price, presumably one that suits his or her needs. This practice does not protect the producer against downward price movement except to the extent that he or she keeps the premium on the option contract. In this sense, if prices fall, a producer writing covered calls is better off by the amount of the premium income received than if the cash position is not hedged. However, if prices rise, the producer is not able to participate in the market rally, although he or she may, nonetheless, receive a price sufficient to cover production costs and provide a satisfactory profit margin.

A second practice which generates premium income involves contracts which incorporate both written and purchased options. A contract having a cap and floor is an example of this practice. In conjunction with a long cash position, these contracts set a floor price for the commodity. The cost of providing that floor, however, is reduced in return for the producer agreeing to limit the upside profit potential, essentially incorporating a written call into the contract. To the extent that such contracts provide for a ratio of written options in excess of purchased options, they raise issues similar to those of writing covered calls or naked options. The Commission should consider and give guidance or create conditions regarding when such contracts fulfill a business-related purpose.

Consideration should also be given to delineating through conditions or guidance whether certain trading strategies are consistent with the requirement that trade options be for a business purpose. For example, a trading strategy used by some is placing a "hedge" when prices are expected to move adversely and lifting the "hedge" when favorable price moves are expected. The motivation behind such a strategy is that being hedged during favorable price moves reduces overall profitably. The success of this strategy depends on the ability accurately to predict future price movements. The Commission should consider whether this, and other risky "hedging" strategies, fulfill a business-related purpose.

2. Restrictions to assure compliance with other legal requirements.

The Commission should also consider whether the design of trade option contracts should be restricted to assure that they do not violate other provisions of the Act or Commission regulations. While a basic option contract is a limited risk financial instrument, options can be bundled to create instruments with more complex payout scenarios. Because option contracts can be "bundled" to create a synthetic futures contract and the regulatory treatment of trade options differs substantially from that of off-exchange futures contracts, the Commission should consider delineating trade options from futures contracts, either through guidance or as a condition of the exemption.

For example, a producer may desire to hedge production by synthetically creating a minimum-maximum price contract. To do so, he or she would purchase a put option and sell a call option. Such a combination of options can also be described as a split-strike futures. If the two options have identical strike prices, the position is simply a synthetic futures contract. Such combinations of options, particularly when acquired and relinquished as a package, raise the issue of when such packages constitute illegal, off-exchange futures contracts.

Recognizing the importance of this issue, several participants in the December Roundtable recommended that the Commission clearly delineate or define which instruments would be considered to be within the exemption for "trade options."⁽⁵⁹⁾ As one roundtable participant noted, "[i]f the ban is lifted, it is critical that we better define trade options and retain guidelines on what and how these new trade options can be used."⁽⁶⁰⁾

C. Regulation of marketing.

Regulation of marketing may be appropriate. Such regulation might include disclosure requirements and account confirmation requirements.

Required disclosures are a common customer protection. Currently, two differing types of disclosures are required to be provided to option customers, depending upon whether the specific option transaction is exchange-traded or a dealer option. Offerors of trade options are exempt from the lengthy disclosure otherwise applicable to the offer or sale of off-exchange options.⁽⁶¹⁾ The Commission, in determining whether required disclosures should be mandated in connection with lifting the ban on agricultural trade options, must also determine the nature of the disclosure that is appropriate to this instrument.

In general, FCMs and introducing brokers (IBs) are required to disclose information regarding the risks, mechanics and costs associated with exchange-traded options. Commission rule 33.7. This disclosure must warn about market volatility, the potential for a complete loss of the option premium, risks associated with being exercised against, the risks of various trading strategies, the effect of limit moves in an underlying futures contract on an option's value and the amount by which the underlying commodity price or futures price must move to cover the costs of obtaining the option. In addition, the disclosure must include a description of trading mechanics. Finally, disclosure information regarding various costs must be provided.⁽⁶²⁾

Disclosures required in connection with the offer or sale of dealer options, as with exchange-traded options, generally relate to the risks, costs and mechanics of dealer options.⁽⁶³⁾ Commission rule 32.5. These disclosures are tailored to the specific characteristics of the instrument and its trading environment. For example, offerors of dealer options are not required to disclose information about the impact of futures contract price limits on option values. Dealers, however, must disclose that generally an option customer will be unable to sell any option purchased to recover any of the purchase price, but rather may only liquidate the option by exercising the option before its expiration date. In addition, the disclosure requirements on dealer options do not contain requirements to disclose the risks of specific combinations of option, futures and cash market positions.

Consideration of the nature of the required disclosure, if any, should weigh the benefits of disclosure against the associated costs. The benefits of requiring disclosure will depend upon the sophistication of customers and the usefulness of the disclosure. If the Commission chooses to limit access to agricultural trade options to more sophisticated individuals and entities, disclosure requirements may result in fewer benefits. However, if access to trade options is broadly available to all commercial agricultural participants, a higher overall level of benefits may be obtained from required disclosures.

Moreover, requiring periodic information regarding accounts is a common customer protection that should be considered. Customers in exchange-traded markets are kept apprised of the financial condition of their market positions in two ways. One is through margin calls resulting from the daily marking of positions to settlement prices. The second is through periodic account statements showing the value of a customer's account. While margin requirements and the marking of positions to the market are not typically a feature of over-the-counter markets, the value of a customer's position could be calculated based on current representative quotes by option vendors and reported to customers. Such information would be useful to customers in guiding them as to the current value of their position and determining the prudence of their future activities.

D. Other possible limitations.

Additional possible limitations include requirements for cover or other methods for addressing risk of possible default and requirements regarding the establishment of appropriate internal controls.

1. Required cover of market risk.

As noted, a major concern when entering

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Additional Information

Policy Alternatives Relating to Agricultural Trade Options and Other Agricultural Risk-Shifting Contracts

DIVISION OF ECONOMIC ANALYSIS COMMODITY FUTURES TRADING COMMISSION May 13, 1997

DIVISION OF ECONOMIC ANALYSIS
COMMODITY FUTURES TRADING COMMISSION
May 13, 1997