THE CFTC AND HEDGE-TO-ARRIVE CONTRACTS
Remarks of
Joseph B. Dial, Commissioner
Commodity Futures Trading Commission
AAWCO 58TH Annual Summer Conference
Omaha, Nebraska
July 30, 1996
Introduction
Good afternoon, I'm glad to be able to join you here today. Having spent 35 years farming and ranching in South Texas before I was appointed to the CFTC in 1991, I always appreciate a chance to get out of Washington and get back in touch with the real world. I'm also grateful to be assigned a time on the program that doesn't conflict with an Olympics telecast. Even back in Washington, the Olympics are quite a distraction. They have not, however, interfered with preparations for the "political Olympics" this fall. I can assure you that folks in D.C. are maintaining their strict training schedules in mud slinging, bull throwing and all those other election year events you enjoy so much.
My topic this afternoon -- the CFTC and HTA contracts --is a very serious one. The restructuring of federal agricultural programs is giving farmers tremendous new economic opportunities -- the chance to farm for the market, and not for the government. At the same time, however, this process also exposes farmers to new and greater degrees of market risk.
Farmers can help to protect themselves against this risk through the prudent use of risk reducing strategies, including exchange-traded futures and options or a variety of innovative hybrid cash contracts. The key word in this formula is prudence. Where farmers or elevators use these marketing tools imprudently -- where they do not fully understand the potential consequences of a given strategy -- or where they choose to disregard a worst case scenario that "just couldn't happen," in trying to squeeze out a few extra dollars of profit -- they may be creating risk rather than controlling it. Such appears to be the case for many users of hedge-to-arrive (HTA) contracts.
I will not go into the mechanics of HTA contracts since this morning's speakers have already covered that ground. Rather, I will try to give you the CFTC perspective on hedge-to-arrive contracts, in three basic areas. First, I will provide an overview of the statutory and regulatory background against which the HTA controversy is being played out. Second, I will review some recent CFTC actions directly addressing HTA issues. Then I will summarize the first two areas, and fill in some additional details, through a series of overheads. Finally, I will close out the presentation with a look ahead at where we go from here, and a review of the 1996 Chicago Board of Trade corn futures contract expirations.
Statutory and Regulatory Background
Federal regulation of contracts for future delivery of basic agricultural commodities dates all the way back to the Futures Trading Act of 1921. Since that time, a cornerstone of regulatory policy regarding contracts for the future delivery of commodities has been the requirement that such contracts may be traded only on federally-designated exchanges. Since 1975, when it first began operations, the CFTC has been charged with enforcing the Commodity Exchange Act (the Act), including that exchange-trading policy.
In other words, off-exchange futures contracts are illegal. Under current regulations, off-exchange options in agricultural commodities are likewise prohibited -- even "trade options," offered to a producer, processor or commercial user, which are allowed in non-agricultural commodities. At some point in the future, the agricultural trade option ban may be lifted -- CFTC staff economists are currently studying that very issue -- but for now, off-exchange agricultural futures or option contracts are illegal.
CFTC jurisdiction does not, of course, extend to cash sales of physical commodities for immediate delivery. A jurisdictional carve-out also exists for forward contracts -- cash sales of physical commodities for deferred shipment or delivery. Even though forward contracts do involve delivery in the future, they are subject to a self-executing exclusion from CFTC jurisdiction. Thus, forwards are not required to be traded on exchanges and are generally governed by state, not federal, law.
As new types of hybrid agricultural contracts have evolved in recent years, the trick for market participants -- and the CFTC -- has been where to draw the jurisdictional lines. How does one distinguish between off-exchange futures and options, which are illegal, and cash or forward contracts, which are both legal and outside the CFTC's authority. This task is complicated by several factors:
(1) The contracts themselves tend to evolve. An instrument that starts out as a clearly excluded forward contract may have this term revised at a producer's request, or that term added by an elevator seeking to offer a more attractive contract. By the time it's been passed around and retyped a few times, it can mutate into a legally questionable instrument.
(2) The legal status of a contract is affected by the course of dealing between the parties and the representations they have made to each other. An instrument that appears to be legal on its face may be called into question if the actual dealings between the parties show they didn't really intend to abide by those written terms. For example, where the contract states that delivery is required, but the parties routinely allow cash offset -- a hallmark of futures trading.
(3) A heavy-handed regulatory approach could be very harmful. Where instruments involving the forward contracting of grain have raised questions under the forwards exclusion, the CFTC has exercised its authority cautiously in light of Congress' recognition of the legitimate commercial nature of forward transactions and the potential for disrupting a vital commercial market.
These same concerns apply equally to HTA contracts -- by whatever name they may be called -- as well as any other varieties of hybrid contracts that may be floating around out there. There simply are no quick and easy answers, and the CFTC has tried to adopt a careful, balanced approach in this area.
Let me note in passing one other legal pitfall that may affect those involved in offering agricultural risk management contracts - - the CFTC's registration rules. The Commission has detailed regulations requiring commodity market professionals to register with the agency, undergo background checks, provide risk disclosures to customers, and so on. The registration categories include futures brokers (referred to in the regs as futures commission merchants or FCMs), Introducing Brokers and Commodity Trading Advisors. Depending on the contracts offered, the services provided, and the dealings between the parties, it is possible that some individuals engaged in offering HTAs or other hybrid contracts may run afoul of the CFTC's registration rules.
CFTC Actions Directly Addressing HTA Issues
With that background, let me turn to CFTC actions directly involving HTA contracts. Over the past year, the CFTC has received many inquiries about various commodity contracts between farmers and their local elevators, primarily involving corn. These contracts are known by various names, including "HTA," "Flex HTA," and "HTA Plus." The contracts had names, terms and usage that varied widely from region to region around the country, and even from one elevator to the next within a region. It appeared that these contracts were centered in various parts of the corn belt -- particularly in Iowa, Minnesota, Michigan, Ohio and Nebraska. It also appears that the course of dealing surrounding some HTA contracts evolved over time, with significant changes taking place last fall as agricultural markets became more volatile.
The many inquiries we received about HTA contracts, in combination with a period of unprecedented market volatility, heightened the Commission's desire to provide guidance in a manner that would not be disruptive to the grain markets. Therefore, on May 15, 1996, the Commission staff issued two statements relating to HTAs -- a Statement of Policy and a Statement of Guidance. In issuing these statements, the staff did not express an opinion on the validity or legality of any individual contract. Such determinations must be based on the specific facts and circumstances of each individual HTA.
The Statement of Policy was issued to deal with questions involving delivery. The staff was concerned that some people, who were unable to make delivery under their HTA contracts, might view the forward contract exclusion as an impediment to working out some other type of settlement of the contracts. In other words, they might be afraid that a settlement involving cash payments, rather than delivery, would be used as evidence that the underlying contracts were illegal, off-exchange futures contracts. The goal of the Statement of Policy was to make clear to the agricultural community -- producers and elevators alike -- that cash payments may be part of a separately negotiated agreement used to unwind or restructure existing HTA contracts without creating a violation of the Act.
In issuing this Statement, the staff was not suggesting that HTA contracts must be unwound or restructured using cash payments. Nor was the staff seeking to take sides in the dispute. Rather, the goal was to remove concerns about the Act as a potential barrier to parties seeking to work out a settlement of existing HTAs through some form of cash payments -- and to offer fair and even-handed guidance to parties on both sides of those contracts.
The Statement of Guidance offers prospective guidance to those wishing to use HTA contracts in the future. In essence, the Statement sets out four basic elements that the staff finds necessary for an instrument to adhere to principles of prudent risk management.
Since May 15, the Commission has made a concerted effort to inform the public about the content of the two Statements -- and about HTA contracts in general. We have also worked to provide background information concerning the current market situation and its implications for HTA contracts. CFTC Commissioners and staff have participated in numerous public meetings, such as this, around the country, and we have responded to hundreds of requests for information and calls from affected individuals.
There are also some enforcement-related aspects to the HTA situation. As noted in recent Congressional testimony by Acting CFTC Chairman, John Tull:
... the Commission is aggressively investigating several situations involving hedge-to-arrive contracts. Our Divisions of Economic Analysis and Enforcement have been looking into the HTA situation. Among the issues that they are evaluating are: (1) whether some of these contracts may be illegal off-exchange futures or agricultural trade options; (2) whether certain participants are required to be registered [with the CFTC]; and (3) whether some persons may have committed fraud in the marketing or sales of HTA contracts. The Commission will take appropriate action to address any violations of the law that it may uncover, and it is pursuing its inquiries with resolve, dispatch, and care. Any illegal conduct will not be tolerated.
At this point, let me review and summarize the statutory and regulatory background regarding HTAs and the two May 15 Statements, through a series of overheads.
Where Do We Go From Here?
The final and most important question is: "where do we go from here?" There is no simple answer to that question. A CFTC enforcement action -- when and if the Commission decides to bring one -- certainly won't provide such an answer. An action involving any particular contract would affect only the legality of that specific instrument. It might be of no use at all in helping parties subject to other HTA contracts to sort out liability among themselves -- given the wide variety of HTAs and courses of dealing under them.
Of course, negotiation -- directly or through the offices of a neutral mediator -- is always an option. The Commission has consistently encouraged parties to HTAs to work out their differences by mutual agreement. Indeed, the very purpose of the May 15th Statement of Policy was to remove a perceived barrier to such agreements.
It would be unrealistic, however, to suggest that all HTA disputes can be worked out through negotiation. Given the large amounts of money at stake in some situations and the desperate financial condition of some of the participants -- both farmers and elevators -- I believe it is inevitable that some parties will decide to take their chances in the courts. For the same reasons, I'm afraid that some folks will choose, or be forced into, another legal option -- bankruptcy. Just how claims arising out of HTA contracts will be treated by a bankruptcy court is anybody's guess.
Another possibility -- although a highly unlikely one -- is some type of legislation addressing HTA issues. The Commission has been called to testify about HTAs before both the House and Senate Agriculture Committees. No legislation has been proposed, however -- and even if it had, it would be nearly impossible to push a bill through in the few remaining days of the current session of Congress. By the time the next Congress is up and running, it seems likely that the HTA controversy will have died down, one way or another.
The one thing I can say with certainty about HTAs is that the Commission will continue to monitor closely their potential impact on the markets we regulate. In that context, I would like to close with a review of the 1996 CBOT corn futures contract expirations.
The old-crop corn futures expirations have occurred in the economic context of: projections for critically low U.S. corn and feed grain supplies; very strong export and domestic demand; and concerns for the size and quality of next year's crop, due to adverse weather conditions. Another complicating factor is the diminished delivery capacity on the CBOT futures market resulting from the closing of several warehouses in Chicago last fall. In case things were not interesting enough for the CFTC and CBOT surveillance staffs, the July corn future was used by grain merchants to hedge a substantial number of HTA contracts that producers probably would not be able to deliver grain against before this fall's harvest, if then.
Cash and futures prices for corn rose to all-time record-high levels this spring and summer in response to these fundamental supply and demand factors. The phenomenal increase in prices, and the huge price inversions that developed in the July/September and July/December futures spreads, made it very costly for short hedgers, such as elevators, to roll hedges forward. This was the hedging dilemma faced by those merchants who had entered into HTA contracts with producers who could not deliver the grain this crop year.
Despite all these complications, we believe the July corn future expired in a very orderly manner on July 22. Large short positions associated with HTA exposures appear to have been liquidated early. Our staff paid particularly close attention to traders involved with those contracts, from the time we conducted a series of telephone interviews in May to identify those accounts until the July future expired. We do not think the liquidation of HTAs played much of a role in the expiration overall. During June and July, futures prices were reacting primarily to two market factors: (1) strong domestic and export demand; and (2) growing conditions in the corn belt -- first to a long dry period and then to significant rainfall.
Large traders carrying long and short positions into the final weeks of trading were monitored closely by CFTC and CBOT surveillance staff to ensure that they would not contribute to a disorderly expiration. In that regard, the lessons learned from the price spike on the last day of trading on the March 1996 wheat future were well remembered by all.
It is still early to make any predictions regarding the September corn future, but at this stage everything looks good. Total open interest in that future is below last year's level for comparable dates and there are no unusual position concentrations. While there is still a large price inverse between the September and December corn futures, it is much less than the July-December inverse. Needless to say, we will continue to be vigilant in our surveillance efforts.
Let me leave you with the following thoughts:
The lessons learned from the use of HTA's with the strategy of rolling reference prices from old-crop to new-crop months are as old as time itself. Number one, past performance is no guarantee of future success. Number two, if something sounds too good to be true, then it probably is. Number three, waiting to sell at the top of the market means you won't.
In order to be profitable in the 21st century a producer will have to become a micro-entrepreneur in production agriculture. That means, what he or she learns about marketing, risk management, computers, the Internet, precision farming, biotechnology, financial record keeping and planning, and the use of best management practices, will determine whether they will be successful in the global marketplace. Clearly then, education is the key to moving production agriculture from a brute-force to a brain-force economy.