CURRENT ISSUES AFFECTING AGRICULTURE AND THE CFTC
Commissioner Joseph B. Dial
Commodity Futures Trading Commission
The American Soybean Association
Board of Directors Luncheon
March 17, 1997
Doubletree Hotel - Pentagon City
I appreciate this opportunity to address the American Soybean Association Board of Directors concerning some of the current agriculture-related issues affecting the Commodity Futures Trading Commission, the markets it oversees and the agricultural community as a whole. I will limit my remarks to four especially significant matters: (1) agricultural risk management; (2) agricultural trade options; (3) grain delivery points on the Chicago Board of Trade; and (4) the amendments to the Commodity Exchange Act currently pending before the Congress.
Agricultural Risk Management
On a cherry blossom spring day not quite one year ago, the Federal Agricultural Improvement and Reform (FAIR) Act became law in the US. I think this legislation will have the same effect on public agricultural policy around the world that the collapse of the Berlin wall had on global public economic policy. Just as the fall of Communism encouraged both developed and developing nations to move toward a free market philosophy, so too has the fall of price supports and production controls pushed producers in many lands to embrace the transition to farming for the market and not the government. We have not seen US agriculture rely this much on the market for almost 70 years. In my mind, this paradigm shift in the government's farm policy has created a new era for agriculture and given a new importance to agricultural risk management.
I believe the success of this grand experiment depends primarily, although not exclusively, on a producer's ability to develop a written marketing program that includes the prudent use of derivative instruments. In order to master this particular task, farmers will have to become business specialists in production agriculture. The reward for improving their business management skills and enhancing their computer literacy through continuing education will be the creation of their own financial safety net. This will occur as growers learn how to secure guaranteed revenue by transferring production and price risks to other parties.
The USDA and the private sector are actively engaged in developing "safety net" risk management tools. Generally speaking, these tools fall into two somewhat different categories of contracts with the common objective of seeking to transfer the production and price risks inherent in farming away from the producer in order to guarantee revenue for his/her operation.
The first, and at present the most widely used, is called revenue insurance. This terminology denotes the fact the contract is written by an insurance company. The most prominent examples of revenue insurance are the Income Protection (IP) program offered directly by the Federal Crop Insurance Corporation (FCIC) and Crop Revenue Coverage (CRC), originated by the private sector and reinsured by FCIC. In view of the limited time available, I would like to skip describing the details of these more familiar programs and concentrate on the second category, commonly referred to as revenue assurance. It is not written by an insurance company, it is evolving as we speak, and it will probably be used primarily by agribusiness companies.
One example of a revenue assurance contract between a producer and an agribusiness company might work this way. The company wants to maintain or initiate a long-term business relationship with the grower. Furthermore, the company wants to supply the seed, fertilizer, chemicals, fuel and financing to the farmer -- and manage his/her production and price risks by guaranteeing revenue per acre. There are a number of reasons why the company might want to provide this safety net for the producer, including the creation of both a guaranteed customer and a guaranteed source of supply. However, the agribusiness company would need to be able to transfer the risks it takes on in the process. This would require creation of a new type of exchange-traded revenue futures contract -- a concept which, I am told, is currently on the drawing board. This is just one example of the creative new approaches available to be explored and applied as producers exercise their new freedom to farm.
Agricultural Trade Options
A somewhat simpler risk management tool -- but one which is likewise currently unavailable -- is the agricultural "trade option." A "trade option," in its simplest form, is a contractual agreement between two parties that provides for the payment of a premium in order to secure the right, but not the obligation, to make or take delivery of the commodity described in the contract. Trade options have been used for decades by producers, processors and others involved in metals, energy, and financial products businesses, but they are currently subject to a CFTC regulatory ban for agricultural commodities. Nevertheless, let me illustrate how an agricultural trade option might work if the prohibition was lifted.
For example, a farmer who entered into a trade option contract with an elevator would pay a premium to the elevator for the right, but not the obligation, to deliver a certain quantity of grain within a specified time frame at a price the counterparties had agreed upon when they signed the contract. If the local cash price on the delivery date was higher than the contractual price, the farmer could abandon the option and sell his/her commodity to the highest bidder. There is a strong likelihood the elevator would cover the risk it incurred in granting this option with an offsetting position in an exchange-traded option covering the same commodity.
What is the advantage to the farmer? The contract itself fixes a price that may allow the farmer to lock in a profit -- in effect, a price floor -- while still retaining the opportunity to make more money if the price is higher at harvest. In a worse case scenario, the option at least limits the potential for loss to an amount the producer has decided he/she can afford to self-insure. However, once again, the grower can walk away from the unattractive contract price and sell in the cash market if prices are higher at harvest time.
Another possible use of the agricultural trade option concept would be in the case of "value added" feed grains -- where there is no matching exchange-traded derivative available. For example, a processor enters a trade option contract with a group of farmers like the Kearney (Nebraska) Area Ag Producers Alliance. The counterparties agree on the fob price, the quantity, and the time frame for delivery of a high oil, high protein corn. The processor has specified the delivery dates and quantities to coordinate with all its other purchases in order to achieve a "just in time" delivery system. This delivery arrangement is predicated in part on the processor's need to maximize operational efficiencies, including availability and attractive pricing of rail, barge, truck or ocean freight. Among the other advantages offered by "just in time" delivery are opportunities to adjust to unexpected weather conditions, to achieve some flexibility in matching production to sales, or to take advantage of a better cash or other contracted price at a particular time. Obviously, for the processor there are economic benefits to achieving these results, but it might require changing the quantity the Producers Alliance has agreed to deliver on certain dates. So the processor wants the right, but not the obligation, to take delivery on the set days of a lesser or greater quantity than called for in the contract. The counterparties do know exactly what the lesser and the greater amounts are, because those quantities were specified in the option clause of the original deal. The processor can exercise this right with only 72 hours advance notice prior to the delivery dates spelled out in the contract. However, the number of times the processor can exercise this option within a given time frame is limited by the contract. For these options the processor is willing to pay a premium to the Alliance. If this sounds futuristic, it may be for agriculture, but it is similar to a trade option presently being used daily in the natural gas business.
As I noted earlier, agricultural trade options are currently subject to a regulatory ban. Without going through the whole complex history of that policy, which can trace its roots all the way back to speculative abuses in the 1930s, let me simply report that the Commission is currently awaiting completion of a staff "white paper," due at the end of this month. The "white paper" will lay out some basic policy choices regarding agricultural trade options. Soon thereafter, I expect the Commission to make a decision on whether to retain the ban as is or publish for comment in the Federal Register a proposal to change, modify or lift the prohibition. If and when such a proposal is published, I hope the ASA and other agricultural organizations will weigh in with their comments.
Grain Delivery Points on the Chicago Board of Trade
Another issue with a long and complex history involves delivery points for the Chicago Board of Trade grain futures contracts. The continued reliability of the CBT delivery point system has been an issue for many years, due to several factors, including: (1) the steadily diminishing role of terminal markets in the cash market for grain; (2) the increasing shift of grain flows away from contract delivery points, especially the par delivery point of Chicago; and (3) the continuing decline of cash market activity generally at the contracts' delivery points -- again, particularly Chicago. The last straw in this situation was a precipitous decline in storage capacity in Chicago. Over the past two years, regular warehouse space in Chicago has dropped from 53.9 million bushels to 22.8 million bushels, with one of the three remaining elevators also apparently in the process of closing down, a further reduction in capacity to only 14.7 million bushels. That works out to a 73 percent decline in warehouse space.
In response to this delivery capacity decline, the CBT appointed a Special Task Force in September 1995 to explore possible changes in contract terms to assure adequate deliverable supplies. One year later, in October 1996, the Task Force's recommendations, as modified by the exchange Board, were voted down by the CBT membership by a two to one margin.
At that point, the Commission felt that it had no choice but to invoke 5a(a)10 of the Commodity Exchange Act. That section authorizes a finding that the delivery terms of a contract no longer accomplish the objectives of the section -- that is, they no longer "tend to prevent or diminish price manipulation, market congestion or the abnormal movement of such commodity in interstate commerce." When the Commission makes such a finding - - which it did in a Federal Register notice published on December 26, 1996 -- the exchange has 75 days to submit a rule change to remedy the situation. Absent a satisfactory response, the Commission can itself impose a rule revision on the exchange.
In response to the Commission's action, the exchange appointed yet another task force, and on March fourth, the 75th day, the exchange Board voted to accept the task force's proposal for a new delivery system for corn and soybeans. This proposal represents a radical departure from the current structure. It would create a shipping certificate delivery system based on a single delivery area -- the Illinois River from Chicago to Pekin, Illinois -- with all locations on that stretch of river at par and no alternate delivery points (in other words, no more Toledo). The CBT has scheduled a floor meeting to discuss the proposal on April 1 and a membership vote on April 15.
The Commission, meanwhile, published the CBT proposal in the Federal Register on March 14th in the hopes that public comments will help to build the most comprehensive record possible to assist us in evaluating the new shipping certificate delivery system. The notice requests comment on a series of questions, including such issues as: effective delivery capacity; the deletion of Toledo; eligibility requirements for issuing certificates; the implications of a single delivery area; and the absence of locational price differentials within that area. It is important for the record on these issues to include the views of producers. I hope the ASA, whose members clearly have a significant stake in a smooth running and efficient soybean futures market, will take the time to thoroughly analyze the CBT proposal and provide us with thoughtful comments. The comment deadline is March 31st.
Commodity Exchange Act Amendments
Finally, let me touch on the current legislative situation. As I'm sure you are aware, major amendments to the Commodity Exchange Act are pending in both the House and Senate. The Commission fully supports this legislative exercise. Futures markets have undergone radical changes over the years and it is certainly appropriate to review the Act to make sure it continues to be efficient and effective in regulating those markets. The Commission has endorsed a number of thoughtful provisions in the proposed legislation and has pledged to work with Congress to craft amendments that will modernize the Act while protecting the public interest.
However, there are some sections of the bills that cause us serious concern, particularly the provisions for a professional market or "promarket" exemption. These promarket provisions would essentially eliminate federal oversight of futures exchanges so long as exchange trading was limited to certain so- called "appropriate persons" -- including businesses, proprietorships, partnerships, pension funds, mutual funds, and commodity pools of individual investors, in addition to large institutions. In effect, these provisions could deregulate 90 percent of current exchange volume and create US exchanges with less government regulation than any other futures exchanges in the world.
I should point out that the Senate bill would not permit deregulation of futures markets in the basic agricultural commodities. The Commission's response to this feature has been twofold. First, we have argued that there is no rational basis for drawing a distinction among commodities. If deregulation is dangerous for soybeans, cotton and corn, it is equally dangerous for copper, coffee and crude oil. Second, the Commission is concerned about its ability to protect the still-regulated agricultural markets from spill-over effects on liquidity and trading practices flowing from those unregulated markets trading right next door.
In my view, to suggest that professional traders should be exempt from futures regulations is like suggesting that professional truck drivers should be exempt from the traffic laws. They may be the most experienced drivers on the road, but when they do have a wreck, it's a doozy. And sophisticated, professional traders do have wrecks. I would point to the Barings, Sumitomo and Metallgessellschaft affairs as just three recent examples. Each of those cases involved supposedly sophisticated traders who made monumental blunders leading to losses of over a billion dollars -- in the Sumitomo case, $2.6 billion. And in each case, the little guys -- innocent consumers, market users or stockholders -- also suffered.
I would note in closing, however, that its sponsors have characterized the Senate bill as an intentionally bold approach, designed to provoke discussion -- which it certainly has. I do not believe they see the bill as set in stone and I am optimistic that reason will ultimately prevail -- as it somehow usually does in our legislative system. Thus, I remain hopeful that the final version of this legislation will preserve the regulatory protections that US farmers, business people and consumers have come to expect and rely upon.