Risk Management and Risk Insurance for Farmers -- Will Our Industry Have a Role?"
Commissioner Joseph B. Dial
Commodity Futures Trading Commission
National Grain and Feed Association's 1997 Annual Convention
Hotel Del Coronado
San Diego, California
March 20, 1997
Thank you for giving me an opportunity to speak to your annual meeting. It is an honor for me to participate in a panel Chaired by Tom Coyle and to share the podium with such an "all-star line- up" of distinguished speakers.
My paper will cover four topics. First, the Commodity Futures Trading Commission's (CFTC) regulatory ban on agricultural trade options. Second, changes in delivery terms for the Chicago Board of Trade's (CBOT) corn and soybeans futures contracts. Third, comments on major amendments to the Commodity Exchange Act now pending in both the Senate and House. And fourth, some thoughts on a new era for agriculture.
The CFTC ban on agricultural trade options
In January, under the direction of your outstanding Washington staff, NGFA formally petitioned the CFTC to lift its current prohibition on agricultural trade options. Then on February 13, 1997, in his testimony before the Senate Agriculture Committee, your president, Kendell W. Keith, once again pressed NGFA's case for lifting the ban. I share your interest in having the Commission deal with the ban. To that end, I have worked for three years to bring this issue to a reasonable resolution, and am I pleased to say that at last there seems to be some light at the end of the tunnel.
The CFTC Division of Economic Analysis (DEA) recently stated that it will have a "white paper" setting out policy choices on this issue for the Commissioners to review by the end of March. Soon thereafter the Commission will decide whether it wants to retain the ban as is or publish in the Federal Register a proposal to change, modify or lift the prohibition. There would be a comment period of at least 30 days concerning any proposal that is published. Thereafter, DEA would review all the comments and send the Commission a final proposal for it to consider. Upon Commission approval, any revisions would be published in final form in the Federal Register and the ban would be modified or lifted according to the revised rules.
You can rest assured the Commission will be cautious in its deliberations and measured in its actions concerning the ban on agricultural trade options. All relevant issues will be analyzed and points of view will be given full consideration. There are a number of other commodity organizations that have asked the CFTC to lift the ban. Among them is the American Farm Bureau Federation, which at its annual meeting in Nashville in January of this year resolved that:
We support the conditional elimination of the Commodity Futures Trading Commission (CFTC) ban on agricultural trade options. Agricultural trade options and other hybrid cash contracts should be required to contain risk disclosure statements.
Changes in the delivery terms for the CBOT corn and soybeans futures contracts
When the CBT membership voted down a Special Task Force's proposal to change the delivery terms on corn and soybean futures, the Commission had no other choice than to invoke Section 5a(a)10 of the Commodity Exchange Act. That provision 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 4th, 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. The Commission published this latest 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 as a delivery point; 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 your views. The comment deadline is March 31st.
Legislative proposals in the Senate and House to amend the Commodity Exchange Act
As I'm sure you are aware, major amendments to the Commodity Exchange Act are currently pending in both the House and Senate. The CFTC welcomes appropriate revisions to assure that the Act continues to be an effective tool to regulate a rapidly changing marketplace. However, the Commission has serious concerns about some provisions of the proposed bills, particularly the so-called "promarket" exemptions. These provisions could, in effect, deregulate 90 percent of current exchange trading volume and create US exchanges with less government regulation than any other futures exchanges in the world.
The US exchanges' rationale in support of these promarket provisions is that deregulation is needed in order to meet the competitive challenge of foreign exchanges and over-the-counter (OTC) transactions. It is true that when the CFTC was created in 1974, there were only a handful of foreign competitors and US volume of 25.9 million contracts represented over 80 percent of the world's total. Today, foreign exchanges number 52 and the US share of world volume is only 38.5 percent. But that 38.5 percent represents over 595 million contracts -- more than a twenty- fold increase in just two decades.
In fact, US exchanges have enjoyed remarkable success over the years and that success is continuing. During fiscal 1996, US exchanges launched 92 new contracts and experienced the second highest volume in their history, with the Chicago Board of Trade setting a new world record. In fact, the growth of foreign competition is not a question of regulatory advantages. It is a result of offshore exchanges emulating the US system -- including our regulatory practices. Very little offshore trading is in direct competition with US markets. Rather, it largely consists of contracts that meet local needs -- such as interest rate futures on the home country's sovereign debt -- and contracts that enjoy the built-in advantages of trading on an in-country exchange and during hours when US markets would be closed in any event.
Nor can the need to compete with the OTC market provide sufficient justification for the profound deregulation that has been proposed. Exchanges create a concentration of risk that is simply not present in bilateral OTC transactions and thus present a more serious systemic threat to our economy. A default on an OTC contract primarily affects only the two principals. A default on a futures market can hurt hundreds of producers, processors and other businesses that depend on those markets for hedging, and millions of consumers who -- whether they know it or not -- depend on them for price basing. That is why congress created the CFTC in the first place and gave it the power to protect the public interest in these markets. The CFTC has played a major role in making US futures markets the safest, fairest and most financially secure in the world. It is this regulatory system that is the universal benchmark for other regulators of such exchange- traded derivatives.
Some thoughts on a new era for agriculture
Before I express some thoughts in this final section of my presentation, let me explain what I mean by the phrase, "a new era for agriculture." On a beautiful, cherry blossom spring day in early April 1996, the Federal Agricultural Improvement and Reform (FAIR) Act became law in the U.S. 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 make the transition to farming for the market and not the government. We have not seen U.S. 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.
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.
Given the fact that your association has written the book on risk management for grain elevators and your customers, I will not cover the same ground in that area. However, there are two derivative products you may be interested in hearing about. The first is in the conceptual stage and if it becomes a futures contract it has the potential to work advantageously for crop insurance companies and agribusiness firms alike.
This contract would, for example, settle on the product of CBOT December corn and Iowa Area Yield futures contracts. According to Dr. Dermot Hayes of Iowa State University at Ames, " the expected value of the product of price and yield is equal to the product of the expected values, plus the covariance." The covariance in this instance is a measurement of the tendency of values to move or not to move together. The contract would trade this covariance, and as Dr. Hayes explained, "option premiums on a revenue product would be much less expensive than the sum of option premiums on separate price and yield contracts." Furthermore, speculators in the covariance futures would lay off their risks in the CBOT Area Yield and commodity price futures markets. As a result, this type of derivative contract could possibly reduce the cost of reinsurance for crop insurance companies. It could also afford agribusiness organizations an economical way to lay off the risks they take on when they enter into a revenue assurance contract with a farmer.
The second innovative use of derivatives is in a pilot program initiated by the Enron Company of Houston, Texas. Simply stated, it allows potato growers in Idaho and dairy farmers in New Hampshire to tie the cost of the electricity they use for irrigation and milking, respectively, to the prices of the commodities they produce.
I use these two examples to illustrate several points. First, I am convinced that the private sector can and will provide the tools farmers need to secure revenue. Second, as this new generation of contractual arrangements catches on, I predict we will see over 90 percent of U.S. agricultural commodities being raised by 20 percent of our producers -- the industrialization of American agriculture in the 21st century.
How can this be you ask? Today in the integrated poultry industry you have the top 20 firms that grow and process some 84 percent of the U.S. total annual tonnage of broilers. Tomorrow in the pork industry there is a real possibility 50 mega-producers and 12 processors/packers will turn out nearly 100 percent of all the pork produced in this country. Today's gradual proliferation of branded-beef programs will revolutionize the cattle business over the next ten years. There are already several alliance coordinated models up and running profitably.
For row crops I believe there will be three types of producers. Those who view farming as a hobby/recreational activity. Others who become contract growers because they love farming as a way of life, but for a variety of reasons can't be profitable on their own in the new era. And finally, the business specialists in production agriculture.
The last category will raise most of the value-added crops, which some experts believe will make up 50 percent of all food and feed grains grown in the next century. Under this scenario many of the farmers in the business specialist category will become part of a group like the Kearney (Nebraska) Area Ag Producers Alliance. These producers will guarantee quality and ship identity-preserved grains in unit-train quantities, with delivery dates and quantities coordinated with a processor's "just in time" delivery schedule. The agreements may well be long-term with flexible pricing.
Whether you agree or disagree with my point of view, one thing is certain -- you would be wise in the future to give careful consideration to the things that haven't been done before. As Edgar Guest said in his poem:
The things that haven't been done before
Are the tasks worthwhile today;
Are you one of the flock that follows, or
Are you one that shall lead the way?
Are you one of the timid souls that quail
At the jeers of a doubting crew,
Or dare you, whether you win or fail,
Strike out for a goal that's new?