Remarks of Joseph B. Dial, Commissioner
Commodity Futures Trading Commission
Before the National Cotton Council of America Board of
June 3, 1997
I appreciate this opportunity to address the National Cotton Council of America. Actually, this my second appearance before NCCA in less than a week. Just last Thursday, I had the chance to participate by teleconference hook-up in the public unveiling of NCCA's Cotton Risk Management Network. I must say I was very impressed with your organization's ground-breaking work in combining sophisticated technology and sound risk management practices. Today, I would like to discuss another facet of agricultural risk management -- agricultural trade options. I will briefly cover the definition, history and current status of these important risk management instruments.
Definition of Agricultural Trade Options
A trade option is an off-exchange commodity option offered to a commercial person or entity for purposes solely related to that commercial's business. An option buyer has the right, but not the obligation, to make or take delivery of the commodity. Trade options have many potential benefits. The most obvious is -- they offer producers the ability to lock in downside price protection without cutting off upside profit potential. If the price goes down, the option is exercised and the producer will cover the cost of production, or some other level of price protection he or she has selected. If the price goes up, the producer can forfeit the premium, abandon the option, and sell the commodity in the open market for the current higher price.
Unlike exchange-traded options, these off-exchange instruments can be customized to meet the specific needs of each producer's operations. Also, the party on the other side, the option grantor, will probably be a local handler or processor -- someone the producer already knows and trusts. On the other hand, of course, the producer gains these benefits at the cost of certain inherent benefits of the exchange environment, such as the clearing house guarantee.
History of Agricultural Commodity Options
The history of agricultural commodity options is a long and complex story. I will try to give you a condensed version, just to put the current status of this issue in historical perspective. In 1936, Congress prohibited options trading -- both on- and off-exchange -- in all commodities regulated under the Commodity Exchange Act. The prohibition was a response to a history of manipulation and price disruption in the futures markets attributed to options trading. The prohibition applied to all the "enumerated" agricultural commodities named in the 1936 Act. In subsequent years, as new contracts came on line -- for example, livestock and the soybean complex -- the list of enumerated commodities grew, and so did the reach of the options ban.
In 1974, when Congress created the CFTC, it gave the agency jurisdiction over futures trading in all commodities -- including authority to ban or allow options in the new, non-agricultural commodities coming under regulation for the first time. However, Congress left in place the statutory ban on options in the enumerated agricultural commodities.
In 1978, in response to widespread retail fraud, the Commission banned off-exchange retail options in non-agricultural commodities. The ban did not, however, extend to trade options involving commercial parties. Commercials in the metals and energy fields had been using trade options for years with no problems or abuses and we saw no need to interfere with their legitimate business practices.
In 1981, the focus switched to exchange-traded options. The Commission okayed a pilot program for exchange-traded options in the non-agricultural commodities. The non-agricultural pilot program was such a success that in 1982 Congress lifted the statutory ban on agricultural options and gave the Commission the authority to allow agricultural options. We exercised that authority by adding ag options to the exchange-traded pilot program. Ultimately, the pilot program was made permanent in 1984 and, as you know, exchange-traded options have become a huge success for both agricultural and non-agricultural commodities.
Nevertheless, because of the history of problems and abuses in off-exchange options, the Commission decided to leave the ban on off-exchange agricultural trade options in place for the time being. In 1991, after several years of experience with exchange- traded options, the Commission proposed a rule lifting the ag trade options ban. The comments we received revealed a lack of consensus within the agricultural community on lifting the ban and the 1991 proposal was never enacted. However, ag trade options remained a "live" issue and was discussed at several meetings of the CFTC Agricultural Advisory Committee.
By 1994, I had become convinced that the Commission needed to take another look at giving people in agriculture the same opportunities as those in the metals, energy and financial fields -- the chance to add trade options to their arsenal of risk management tools. In December 1995, the Commission hosted a public roundtable discussion of agricultural trade options. The 17 participants represented a broad cross section of agriculture, as well as academia and the futures industry. While some still expressed reservations, there was general support for relaxing the ag trade options ban, based on an increased need in modern agriculture for a variety of risk shifting tools. The Commission directed its staff to study the issue and report on its findings.
The staff study culminated in a "white paper," published last month, entitled "Policy Alternatives Relating to Agricultural Trade Options and Other Agricultural Risk-Shifting Contracts." The white paper recommends that the Commission consider lifting the agricultural trade option ban, subject to appropriate conditions. The first step in that process is already underway. This week's Federal Register will include an Advanced Notice of Proposed Rulemaking requesting comment on lifting the ban and the appropriate conditions for doing so. The Notice includes a list of some 30 questions and is subject to a 45-day comment period. I would urge all interested parties to submit their comments on time so that the Commission's deliberations can proceed on schedule. It is my hope that the Commission's final action on ag trade options will be completed by this coming October. If the ban is lifted then those who want to use ag trade options for the 1998 crop year will have an opportunity to do so.