REMARKS OF BROOKSLEY BORN
COMMODITY FUTURES TRADING COMMISSION
NATIONAL GRAIN TRADE COUNCIL
May 14, 1997
I am pleased to be here today and to have the opportunity to speak to this important national trade association. In my almost nine months as Chair of the Commodity Futures Trading Commission, I have had the pleasure of meeting with some of the officials of the National Grain Trade Council to discuss areas of interest to them. I hope that dialogue will continue here today.
In my remarks today, I would like to focus first on the Agricultural Trade Options White Paper prepared by Commission staff and released today at the meeting of the Commission's Agricultural Advisory Committee in Washington, D.C.; and second, on the proposed legislation currently pending in Congress to amend the Commodity Exchange Act, the law governing futures and option trading.
Earlier today, the Commission released a white paper prepared by the Commission's Division of Economic Analysis entitled, "Policy Alternatives Relating to Agricultural Trade Options and Other Risk-Shifting Contracts." During the past 15 years, the Commission has considered lifting the ban on trade options on the basic agricultural commodities enumerated in the Commodity Exchange Act three times. As it has deliberated on this difficult issue, the Commission has sought input from producers and commercial users in agriculture and related businesses to ensure that the long-term effect of its decision would be to foster the integrity and growth of important agricultural markets. The Commission's task has been complicated by the lack of consensus among agriculture interests on this issue. Various sectors of the agriculture community have voiced strong support for preserving the ban; others have expressed equally strong support for lifting the ban. The Commission is again turning its attention to this complex issue.
The Commission's task is further complicated by the profound changes affecting our agricultural markets. The major shift in farm policy embodied in the Federal Agriculture Improvement and Reform (FAIR) Act of 1996 means that, now more than ever, agricultural producers will be required to be responsible for managing their market risk themselves. They must be equipped with effective and safe risk management tools to do so. Producers facing this increased responsibility may need to have a better understanding and knowledge of marketing tools and new products in order to manage their own risk.
The Commission recognizes that these changes in agriculture and the development of new forms of risk-shifting instruments require reexamination of its regulations to ensure that its regulatory scheme is keeping pace with the demands of these changing markets. It was against this backdrop that the white paper was undertaken.
The white paper analyzes the current regulatory environment, recent developments in agriculture which have expanded the need for risk-shifting strategies, the benefits and risks of agricultural trade options, and ways to strike a balance between such benefits and risks. Based on this analysis, the white paper concludes with a series of staff recommendations for the Commission to consider.
The white paper suggests that a central benefit from removing the current ban on agricultural trade options potentially would be to provide producers and users of agricultural commodities with a greater variety of risk- management tools. Other benefits derive from customization to meet particularized needs. Customization permits more precise matching of hedges to amount, timing and other commodity characteristics. The white paper additionally cites various benefits from increased competition -- such as the potential increase of the supply and variety of agricultural options and lower costs to users.
The white paper also articulates various risks associated with trade options -- risks that stem from the marked difference in the markets for exchange-traded options and off-exchange options. The white paper highlights six sources of risk that cause concern: fraud, credit risk, liquidity risk, operational risk, systemic risk, and legal risk.
Acknowledging that removing the current ban on agricultural trade options involves both potential benefits and risks, the white paper suggests that an appropriate balance could be struck by lifting the ban subject to certain conditions. There are three categories of regulatory conditions discussed in the white paper: 1) restrictions on eligibility of parties; 2) restrictions on the instruments and their use; and 3) regulations on the marketing of the instruments.
Eligibility requirements could take various forms including restricting the availability of agricultural trade options to sophisticated individuals or entities. Another method of limiting access to agricultural trade options is to limit those entities or individuals which may become trade option vendors. Thus, for example, the Commission could require option vendors to register as a condition of doing business. In lieu of or in combination with registration, the Commission could restrict vendors of trade options to commercial entities involved in the handling or use of the commodity. The Commission could also impose an education requirement on either buyers or sellers or both.
The white paper suggests that 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," as required by the language of the current non-agricultural trade option rule. 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.
A further set of suggested conditions relates to the regulation of marketing, such as disclosure requirements and account confirmation requirements, methods for addressing risk of possible default and requirements regarding the establishment of appropriate internal controls.
The Division of Economic Analysis concludes with a series of five recommendations to the Commission. One recommendation is that the Commission consider lifting the ban on agricultural trade options subject to appropriate conditions. Those conditions might include some combination of the conditions referenced above, but they could also include other conditions that industry participants deem important. The Commission plans to publish this recommendation for public comment along with an abbreviated version of the white paper and would welcome the comments of all industry participants as to what conditions, if any, are important if the ban on agricultural trade options is to be lifted. It is important that the complex issues raised in the white paper and the views of interested persons on them be carefully considered so that the best regulatory policy can be crafted -- a policy that both protects the public interest and recognizes the need of agricultural interests to manage their market risks wisely.
The same standard should be used to evaluate the legislation pending before both the Senate and the House. These bills -- if adopted -- could have a significant impact on both exchange- traded and over-the-counter derivative markets. As with the ban on agricultural trade options, it is an appropriate time to reexamine the Commodity Exchange Act to determine whether it continues to be effective and efficient in regulating our futures markets. These markets have changed over the years, and the Act may require amendment to reflect those changes.
Both the House and the Senate bills include a provision exempting so-called professional markets from nearly all provisions of the Commodity Exchange Act. Federal oversight of the futures exchanges could be eliminated as long as exchange trading was limited to entities with a net worth of $1 million. These traders include small businesses, proprietorships, partnerships, pension funds, mutual funds, and commodity pools of individual investors, as well as large institutions. The exchanges estimate that approximately 90 percent of their current trading volume is on behalf of such entities. Therefore, it is likely that simple exchange rule changes could convert many markets into professional markets subject to no meaningful federal oversight.
The deregulation of exchange trading possible under the professional markets exemption would greatly restrict federal power to protect against manipulation, fraud, financial instability and other dangers. While the bills preserve CFTC jurisdiction to bring fraud and manipulation cases after the fact, that limited authority might provide only an illusion of protection. The Commission would be stripped of many of its regulatory tools designed to prevent those abuses from occurring and to detect them when they do occur.
For example, statutory and regulatory requirements designed to detect and deter fraud and cheating of market participants, such as those relating to exchange audit trails, competitive trading and open pricing, would cease to exist. The proposed professional markets provision also sweeps away many regulatory tools designed to safeguard market integrity. There would be no Commission surveillance of the professional markets, and requirements such as speculative position limits, large trader reporting, and exchange recordkeeping would be eliminated. Thus, the Commission would not have the data to analyze aberrational price movements on the markets, including suspected price manipulation. Exchanges also would not be subject to any of the current legal standards relating to their contracts, rules or governance.
Commodity professionals trading exclusively on exempt markets would no longer be subject to registration, fitness requirements and sales practice standards. Statutory and regulatory standards relating to the financial integrity of the markets and their participants would be eliminated. The standards abolished would include segregation of customer funds, net capital requirements, financial reporting, margining of accounts and special bankruptcy protections. In sum, the bills could eliminate seventy years of government protection of the integrity of our markets.
The bill pending in the Senate, unlike the House bill, would not permit deregulation of futures markets in certain domestic agricultural products, presumably on the grounds that it would be too dangerous to do so. The Commission believes that futures markets in other products -- energy, metals, tropical agricultural products, and financial instruments -- deserve the very same level of regulatory protection as agricultural products.
Moreover, the Commission is extremely concerned about whether it would be able effectively to regulate and to protect markets in agricultural products that would trade side-by-side on the same exchange with totally unregulated markets. For example, the Commission seriously questions whether the funds related to regulated and unregulated trading should be handled by the same clearinghouse. Significant public policy concerns would be raised by subjecting funds relating to the regulated market to the risks of the unregulated markets.
The Commission also is concerned about the impact of unregulated markets on the liquidity of the regulated agricultural markets. The unregulated markets might siphon off speculative trading from the regulated agricultural markets, thus reducing their liquidity and usefulness. These same concerns have been expressed by Dan Glickman, the Secretary of Agriculture, and by a coalition of agricultural interests which opposed the professional markets provision in testimony before the House Subcommittee last month.
The exchanges have said that they should be able to operate in the same unregulated environment as the over-the-counter markets -- a result that the pending legislation is designed to achieve. There are differences between these markets, however, and the appropriate regulatory framework must depend on an analysis of the characteristics of the particular market.
Exchange trading involves important public interest considerations that require a higher level of regulation than over-the-counter markets. The use of centralized clearing in exchange trading, for example, creates a concentration of financial risk not present in bilateral over-the-counter transactions. That concentration of risk poses more serious systemic threats to our economy than the decentralized risk of the over-the counter market.
While both exchanges and the over-the-counter markets perform a vital public service in providing hedging opportunities, there is also a strong public interest in protecting the price-discovery and price-basing functions uniquely performed by exchanges. The prices established by the futures exchanges affect trillions of dollars of commercial transactions and ultimately the retail prices for many commodities. This price-discovery function requires protection even if particular sophisticated traders do not.
The U.S. has had more than 70 years of successful futures market regulation -- regulation that has produced the most competitive, most dynamic and most innovative futures markets in the world. The pending legislation would discard this regulatory framework on the theory that the self-interest of private market participants will protect not only those participants but the marketplace as a whole. History makes clear that the self- interest of the exchanges and their members at times conflicts with the interests of agricultural and business entities which rely on the markets and with the interests of the American consumer. That is why government regulation is necessary.
The Commission believes that the regulatory regime is crucial if these markets are to continue to serve their critical price discovery and hedging functions. The Commission is committed to working with the futures industry, market users and Congress to ensure that any changes keep pace with the changing markets and protect the public interest in strong, safe and transparent futures markets.