TESTIMONY OF BROOKSLEY BORN
COMMODITY FUTURES TRADING COMMISSION
CONCERNING AGRICULTURAL TRADE OPTIONS
SUBCOMMITTEE ON RISK MANAGEMENT AND SPECIALTY CROPS
U.S. HOUSE OF REPRESENTATIVES
JULY 23, 1997
Mr. Chairman and members of the Subcommittee, thank you for providing the Commodity Futures Trading Commission with the opportunity to discuss agricultural trade options before the Subcommittee today. I am confident that today's hearing will have a dual benefit: informing the Subcommittee about an issue important to the agricultural community and assisting the Commission in its current consideration of whether to lift the ban on agricultural trade options. Accompanying me are Commissioners John E. Tull, Jr., Barbara Pedersen Holum, and David D. Spears.
My testimony on behalf of the Commission will focus on three areas: a history of options on agricultural commodities; a discussion of the Commission's staff White Paper on agricultural trade options; and a description of the Commission's process for reviewing whether to lift the ban on agricultural trade options.
Options are transactions that grant one party the right, but not the obligation, to buy or to sell a commodity or other interest at a certain price. Options trading can be broken down into two broad categories - exchange-traded options and off-exchange options. Trade options are off-exchange commodity options which can be offered only to a commercial person or entity solely for purposes related to that person's business. Trade options are currently prohibited on certain agricultural commodities listed in the Commodity Exchange Act, although permitted on other commodities.
If agricultural trade options were permitted, a corn farmer could purchase an option from an elevator to sell the farm's anticipated production of corn at a certain price. Similarly, a wheat miller could buy an option to purchase wheat from a grain dealer for processing at a certain price.
Agricultural options - both on- and off-exchange -- were traded in the United States at least from the time of the Civil War until the 1930's. However, concerns about fraudulent sales practices, failures to perform on over-the-counter obligations, and the use of exchange-traded options to manipulate the prices of agricultural commodities prompted numerous industry and government efforts to limit or to eliminate trading in agricultural options. In 1936 Congress banned all sales of options on certain agricultural commodities listed in the Commodity Exchange Act. Today, those listed commodities include the major grains, oilseeds, cotton and livestock products, among others.
Congress's ban did not apply to all commodities, and fraud and abuse in options markets in non-listed commodities, such as gold, was one of the reasons for creating the Commodity Futures Trading Commission in 1974. The 1974 amendments to the Commodity Exchange Act vested the Commission with broad-based authority over both on-exchange and over-the-counter options markets in non-listed commodities, but left in place the 1936 ban on options in the listed commodities. Shortly after its creation, the Commission adopted rules that exempted over-the-counter trade options in non-listed commodities from most regulatory requirements. However, the Commission retained the power to enforce fraud and manipulation prohibitions as to such trade option transactions.
Despite historical problems associated with commodity options, there remained considerable commercial interest in their use. Accordingly, in 1981 the Commission instituted a pilot program for exchange trading of commodity options in commodities other than the listed agricultural commodities. In 1982 Congress lifted the 1936 statutory ban, allowing the Commission to permit options in the listed agricultural commodities. The Commission permitted exchange trading in these agricultural options in 1984. However, the regulatory ban on agricultural trade options was maintained.
The reintroduction of exchange-traded commodity options has been a commercial and regulatory success. Neither they nor trade options on the non-listed commodities have posed unusual regulatory problems.
Although the Commission has considered lifting the regulatory ban on agricultural trade options several times over the last 15 years, the Commission has not acted to reintroduce trade options on the listed agricultural commodities, choosing instead to leave the ban in place. There have been deep divisions within the agricultural community on the issue. Opponents of lifting the ban have expressed concerns over possible fraudulent activity and suggested that such contracts might result in confusion in the producer community, particularly regarding the delivery obligations. Nonetheless, there also have been repeated calls throughout the years for the Commission to permit broader use of trade options in the agricultural sector.
Earlier this year the Commission asked its Division of Economic Analysis to prepare an analysis of the issues surrounding agricultural trade options. The Commission's request in part reflected increased producer interest in additional risk management tools in light of the significant changes in U.S. farm policies enacted in the 1996 Federal Agricultural Improvement and Reform (FAIR) Act. In May 1997, the Division's staff completed a White Paper entitled "Policy Alternatives Relating to Agricultural Trade Options and Other Agricultural Risk-Shifting Contracts," a copy of which is attached to our testimony.
The White Paper analyzes the current regulatory environment, recent developments in agriculture that have expanded the need for risk-shifting strategies, the benefits and risks of agricultural trade options, and possible 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.
A central benefit identified in the White Paper is that lifting the ban on agricultural trade options potentially would provide producers and end-users with a greater variety of risk-management tools. Other benefits derive from customization to meet particular needs. Customized options would permit more precise matching of hedges to amount, timing, quality, and other commodity characteristics. The White Paper additionally cites benefits from increased competition, such as the potential increase of the supply and variety of agricultural options and possible lower costs to users.
The White Paper also describes various risks associated with trade options. Six risks are highlighted in the white paper: fraud, credit risk, liquidity risk, operational risk, systemic risk, and legal risk.
The White Paper suggests that the Commission should consider whether to lift the ban subject to appropriate regulatory conditions. Three categories of conditions are discussed in the White Paper: (1) restrictions on eligibility of the parties; (2) restrictions on the instruments and their use; and (3) regulations on the marketing of the instruments.
Based on the White Paper, the Commission decided to seek public comment on whether the Commission should lift the ban and, if so, what regulatory conditions would be appropriate. A Federal Register notice dated June 9, 1997, requested interested persons to address a number of specific questions that would assist the Commission in its deliberations on whether to issue a proposed rule to lift the ban on agricultural trade options. A copy of the Federal Register notice is attached to our testimony. Written comments are due to the Commission by July 24, 1997.
The Commission has just completed two field meetings on the subject. All five of the Commissioners attended the meetings in Bloomington, Illinois, and in Memphis, Tennessee. The statements by interested persons at the meetings were very thoughtful and informative. After analyzing and considering all public comments, the Commission will determine whether to propose a rule lifting the ban on agricultural trade options. If it were to decide to do so, the proposed rule would be published, and public comment on the proposal would be solicited and considered prior to any decision whether to adopt a final rule.
The Commission is committed to considering this important issue carefully in light of the history of options trading, the increasing need for price risk management by agricultural producers, the views of all interested persons and a thoughtful weighing of risks and benefits. Thank you again for the opportunity to appear before you today. The Commission looks forward to working with the Subcommittee on agricultural trade options and other matters.