Accountants, Farmers and Futures: Current CFTC Issues

Joseph B. Dial, Commissioner

Commodity Futures Trading Commission(1)

Annual Agribusiness Conference

Illinois CPA Society and Foundation

Springfield, Illinois

September 5, 1997


I would like to thank the Illinois CPA Foundation for inviting me to address this distinguished gathering -- and for giving me the opportunity to visit some part of Illinois other than Chicago. Don't get me wrong, I have nothing against Chicago. It's a wonderful city. But as a former agricultural producer, I have to say, it's nice to visit a part of Illinois where one can see something sprouting from the ground besides parking meters.

I have been asked to cover three subjects: (1) the CFTC's position on the Financial Accounting Standards Board (FASB) proposal to change the accounting treatment of hedge transactions; (2) the Commission's ongoing rulemaking proceeding to consider lifting the ban on agricultural trade options; and (3) internal controls as they relate to agribusiness firms and farmers. Because there is very little overlap among these topics, I believe the most useful way to proceed will be to give my remarks as three separate and distinct presentations, each followed by a Q&A period.

The Proposed FASB Rules

Turning first to the proposed FASB hedge accounting rules, I would like to preface my remarks with a disclaimer. While the CFTC employs a number of highly skilled accountants, I am not an accountant myself. In fact, when I must deal with our accounting staff on technical issues, I usually ask them to bring along a lawyer or an economist to serve as a translator. Therefore, my remarks will be rather general in nature and will not go into a great deal of detail about the technical fine points of the FASB proposal. I will try to cover four areas: (1) the basis for the CFTC's interest in hedge accounting issues; (2) the history and rationale behind the FASB proposal; (3) the significant issues in that proposal from the CFTC's viewpoint; and (4) the current status of the FASB proposal. At the conclusion of the presentation, I will entertain questions. If anyone comes up with a technical question that stumps me -- possibly the easiest challenge you will face during this entire conference -- I would ask that you put it in writing and I will pass it along to our accounting staff for you.

Basis for the CFTC's Interest in Hedge Accounting Issues

The CFTC is an independent federal regulatory agency charged with overseeing an important segment of the derivatives market -- exchange-traded commodity futures and options. Those exchange-traded derivatives perform two vital functions for our nation's economy -- hedging and price basing. To assure the proper performance of those key economic functions, the CFTC administers comprehensive rules intended to preserve market integrity, financial integrity and customer protection. The CFTC is interested in the FASB accounting rules only insofar as those rules might impose any unfair burden on the industry we regulate or interfere with that industry's ability to perform its vital hedging and price basing functions.

For example, all futures brokers -- known as futures commission merchants, or FCMs, in CFTC parlance -- are registered with the CFTC and are subject to agency-imposed minimum net capital rules. The CFTC would not want the FASB's accounting rules to create arbitrary or unreasonable blips in assets or liabilities that would throw those net capital calculations out of whack. Even more important, we would not want users of the futures market to make important trading decisions -- decisions that could have a significant market impact -- based on some quirk of the accounting rules rather than their legitimate economic needs.

Finally, we would not want the FASB rules to put exchange-traded futures markets at a competitive disadvantage to over-the-counter (OTC) derivatives. In as much as futures markets do perform vital economic functions, we don't want to see those functions diminished. Nor do we want to see futures volume bled away to unregulated, non-transparent markets, merely because of some arbitrary glitch in the way the accounting rules are drafted or applied.

History and Rationale of the FASB Proposal

The history of the FASB proposal is laid out succinctly in an article by Henry Davis in the July 1997 issue of Risk Magazine. It all started with the "Financial Instruments Project," begun in 1986. Within the context of that project, recognizing that existing guidance was inconsistent and incomplete, FASB began deliberating in 1992 on new, comprehensive standards for derivatives and hedge accounting. In 1995, the Board even considered doing away with hedge accounting altogether. This approach would have measured all derivatives at fair value on the balance sheet and classified them as either held for trading or held for risk management. Derivatives held for trading would have been marked-to-market constantly. Derivatives held for risk management would have had their gains and losses carried in a separate account and not recognized until the corresponding earnings were realized.

The basic document at issue in the hedge accounting debate before us today is a June 1996 FASB "Exposure Draft" entitled, "Accounting for Derivative and Similar Financial Instruments and for Hedging Activities." This draft would preserve the idea of measuring derivatives at fair value and recognizing them on the balance sheet, but return to the concept of hedge accounting for hedging instruments, hedged assets and liabilities, firm commitments and certain forecast transactions. As described in the Davis article, the exposure would allow hedge accounting for three types of transactions:

a fair value hedge -- a hedge of the exposure of a recognized asset or liability to changes in fair value;

a cashflow hedge -- a hedge of the exposure of a forecast transaction to variable cashflows; and

the hedge of a foreign currency exposure of a net investment in a foreign operation.

In July of 1997, after reviewing more than 240 comment letters on the June 1996 Exposure Draft, FASB issued a summary of what it described as "tentative decisions" made during the Board's "partial redeliberations" of the issues in the Exposure Draft. That brings the history of the FASB proposal up to date. What happens next in the process I will describe later in the context of the proposal's current status.

Turning now to the rationale behind the Exposure Draft, concern had grown within FASB, and the accounting profession in general, that balance sheets have not accurately portrayed derivatives exposure. Currently, most derivatives don't show up on balance sheets because they don't have a "historical cost" -- defined as the amount a dealer would be willing to pay to buy or sell a derivatives contract on the day it is entered into. As the volume of derivatives transactions -- both exchange-traded and OTC -- has grown, stockholders have sometimes been blindsided by derivatives losses that were not adequately exposed on company balance sheets. One well-publicized example of such a loss was the subject of a 1994 CFTC enforcement action. In December 1994, BT Securities agreed to payment of a $10 million civil penalty, along with other relief, to settle companion enforcement actions by the CFTC and the SEC relating to material misstatements by BT Securities to its derivatives customer, Gibson Greetings. By misleading Gibson about the magnitude of its derivatives losses, BT "caused Gibson to make material understatements of the company's unrealized losses from derivatives transactions in its 1992 and 1993 notes to financial statements."

To prevent the publication of misleading financial information and provide accurate disclosure of derivatives exposures, the FASB rules are intended to bring derivatives onto corporate balance sheets so that investors and others can appreciate their potential impact. The affected companies say they don't object in principle to disclosing their derivatives exposure, but the devil is in the details and there has been a great deal of controversy concerning the proper way of accounting for that exposure. In particular, where the derivatives are part of a hedge, there has been a concern that the accounting treatment should accurately reflect the total hedging strategy, without causing financial statements to reflect earnings volatility that isn't really there.

Significant Issues from the CFTC's Viewpoint

The primary concern expressed in the Commission's comment letter on the June 1996 Exposure Draft related to parity of treatment between exchange-traded and OTC derivatives. The letter states that, "the Commission believes that it is important that the same accounting treatment -- that is, deferral of gains and losses or immediate income recognition -- should be accorded an economic hedge transaction, regardless of the type of derivative product chosen as the hedging instrument." The CFTC's particular problem related to roll-over hedges -- a situation where a firm seeking to use futures to hedge a longer term cash market risk might find that a futures instrument with a maturity long enough to match the cash exposure is not being traded or is prohibitively expensive. Thus, the hedger would need to establish a futures position with a maturity shorter than the cash exposure and subsequently roll the futures hedge forward into a later futures month. Under the Exposure Draft, gain or loss on the futures hedge would have been recognized when it was rolled-over. On the other hand, with an OTC hedge performing an identical function, but structured with a maturity matching the hedged item, the gain or loss would not be recognized until the hedge matured. The Commission argued that this disparate treatment would bias hedgers against using exchange-traded futures in favor of OTC derivatives.

The proposed revisions announced in July 1997 would address this concern by allowing roll-over strategies as long as the hedge matches the underlying risk. More specifically, roll-over strategies may be used to hedge forecast cashflow variability as long as the cashflows of the derivatives used are expected to offset substantially all of the cashflow variability attributable to the risk being hedged.

Other key changes relate to fair value, and cashflow, hedge accounting. With respect to fair value hedge accounting, the Exposure Draft had proposed recognizing in earnings the gain or loss on the hedging instrument along with the entire gain or loss on the hedged item. However, the July 1997 revisions would recognize in earnings only the gain or loss on the hedged item attributable to the risk being hedged. In other words, the hedge accounting rules would no longer require firms to recognize in earnings the fair value of the hedged item not related to the hedge.

With respect to cashflow hedge accounting, the Exposure Draft required that, if a firm discontinued cashflow hedge accounting, the net gain or loss accumulated up to that date would be recognized in earnings on the original projected date of the forecasted transaction. The proposed revisions would allow firms to recognize the gain or loss immediately, since it is probable that the original forecasted transaction will not occur.

Commission staff members are studying other aspects of the FASB proposal and still have three remaining areas of concern. First, complexity -- the proposal requires firms to undertake some rather complex calculations, especially the requirement that they compute the effectiveness of each hedge. Second, confidentiality -- the disclosures required for each hedge are so detailed that they can reveal sensitive and confidential information. Finally, understandability -- firms may have problems understanding and applying the complicated hedge accounting requirements, especially given the relatively short amount of time before implementation.

Current Status of the FASB Proposal

On July 24, 1997, the FASB published a 27 page summary of the "tentative decisions" made to that point during its "partial redeliberations" on the issues aired in the Exposure Draft. The document listed 22 "key changes from the Exposure Draft." The Board is expected to follow up this preliminary document with a final draft or "working model" of the new standards, which would be submitted for comment to the Financial Instruments Task Force, a FASB advisory group, and also made available to the public. Interested parties would be given 45 days to comment. After reviewing the comments, the Board would issue final standards on accounting for derivatives hedging before the end of 1997. The new standards would be effective for all fiscal years beginning after December 15, 1998.

There has been a rather loud chorus of complaints concerning both the specifics of the proposal and the process of going straight to a final standard when there are such extensive changes. The 14,000 member Financial Executives Institute and the 10,000 member Treasury Management Association have both called upon FASB to issue a new Exposure Draft, a step that would probably delay implementation of new standards for at least another year. The Financial Accounting Standards Advisory Council, another FASB advisory group, was split almost evenly on the issue. Some members favored issuing a new exposure draft because of the extensive changes from the earlier document. Others opposed such action on the grounds that those changes were, in fact, responsive to the comments on the June '96 document, ample due process had been given, and issuing a new draft would cause too much of a delay in implementing the new standards.

On July 31, senior executives from 22 major corporations, including the ten largest US banks, and other entities, from Fannie Mae to Goldman Sachs to Hershey Foods, wrote to FASB and the SEC, which enforces FASB standards. The executives expressed concern about FASB going forward with a final standard, without exposing it for pubic comment and debate, especially in view of "the evident complexity of the new approach, the speed with which it has been developed and the significant changes to the exposure draft since it was released more than a year ago." They argued that FASB may not have adequately considered a wide range of concerns, including "the potential impact on the capital markets, the weakening of companies' ability to manage risk, and the adverse control implications of implementing costly and complex new rules imposed at the same time as other major initiatives, including the year 2000 issues and a single European currency."

On that same day, Fed Chairman, Alan Greenspan, wrote an equally strong letter to the Chairman of FASB warning that "The proposal may discourage prudent risk management activities and in some cases could present misleading financial information." He argued that the proposal could "inappropriately increase the reported volatility of earnings," "reduce the reliability of financial statement values," and "potentially permit abuses" arising from over- or understatements of values. In view of all these concerns, Greenspan too favored republishing the proposal, and even went so far as to suggest an alternative approach whereby the fair value of hedges would be reported in a supplement to the financial statement rather than replacing the current system altogether.

There is also a possibility that Congress may weigh in on this issue. Senator Phil Gramm, Chairman of the Securities Subcommittee of the Senate Banking Committee, has criticized the FASB proposal and members of his staff have been quoted in the press as suggesting that hearings before the Subcommittee are a possibility. While Congress has no direct authority over FASB, the Banking Committee does exercise jurisdiction over the SEC, which enforces FASB standards. It was suggested in the press reports that such hearings might look into the whole FASB rulemaking process.

For the moment, however, FASB, with the encouragement of the SEC, appears to be hanging tough. In response to the July 31 letter from banking and business executives, FASB Chairman, Edmund Jenkins, stated:

Companies currently omit from their financial statements billions of dollars in transactions in derivative instruments each year. That makes it difficult for investors to properly evaluate those companies' financial positions and risks. The requirements in the Board's proposal would remedy that lack on information.

In response to Chairman Greenspan's letter, Mr. Jenkins stated, "Your approach - when compared with ours - would reduce the information available to investors and creditors."

The SEC's chief accountant, in a statement released on August 11, supported the FASB position, arguing that "Further delays in the process are unwarranted and put investors at risk." Likewise, SEC Chairman, Arthur Levitt, in a speech in May, argued that the requests for delay on the FASB proposal don't take into account ten years of study and debate on the hedge accounting issue. "These delaying tactics" he said, "are inconsistent with the way the standard-setting process should be conducted." Thus, the battle lines are clearly drawn.

I hope this has given you at least a general overview of the FASB hedge accounting proposal and the CFTC's concerns about it. Speaking as a non-accountant, I find the politics of the process somewhat more interesting than the dry technical issues -- and there certainly seems to be enough politics going on. Fortunately from the CFTC's point of view, the agency's interests in the FASB proposal are relatively discrete, so that in this particular political battle, the CFTC can gladly claim status as a non-combatant.

At this point let me thank you for your kind attention and -- with no small measure of trepidation -- open the floor for questions.

Agricultural Trade Options

The second area I would like to discuss with you today involves agricultural trade options. These instruments, which represent a new and potentially very useful risk management tool for America's farmers, are currently the subject of an ongoing CFTC rulemaking proceeding. I will cover the definition, history and current status of agricultural trade options.

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 that they offer producers the ability to lock in downside price protection without cutting off upside price potential. Thus, for example, a farmer might buy a put option giving him or her the right to sell a portion of their crop to the option grantor at the "strike price." If the market price drops below the strike price, the option is exercised and the producer can sell to the grantor at that price, thereby covering the cost of production, or some other level of price protection that he or she has selected. On the other hand, if the market price goes up, the producer can forfeit the premium, abandon the option, and sell the commodity in the open market.

The grantor, or writer, of such an option might be the local elevator, which also could benefit from trade options in one of several ways. For example, unlike exchange-traded options, these off-exchange instruments can be customized to meet the specific needs of each producer's operations, giving elevators more flexibility in offering risk management opportunities to farmers. They also could provide a chance to generate additional income for the elevator through option premiums. Finally, a trade option is more likely to be accepted by the farmer for the very reason that it is being offered by the local elevator -- a firm he knows and trusts.

On the other hand, the producer gains these benefits at the cost of certain inherent advantages of the exchange environment, such as the clearinghouse guarantee. However, the futures exchanges will still be involved indirectly in the trade option process. Responsible elevators can be expected to cover the net price risk they undertake in writing trade options by themselves entering into exchange-traded options, thereby creating additional volume for the exchange marketplace. Thus, the producers, the elevators and the exchanges all stand to benefit from agricultural trade options.

History of Agricultural Trade Options

That's the good news about agricultural trade options. However, there's one rather significant piece of bad news. Despite their potential benefits, agricultural trade options are currently subject to a regulatory ban. The history of that ban is long and convoluted, but let me 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 then 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 statutory 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 and option 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 agricultural options to the exchange-traded pilot program in 1984. The pilot program was ultimately made permanent and 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, agricultural trade options remained a "live" issue and were discussed at several meetings of the CFTC Agricultural Advisory Committee.

Current Status of Agricultural Trade Options

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. My view was based on several developments, including: (1) the success of off-exchange trade options in non-agricultural commodities; (2) the success of exchange-traded options in both agricultural and non-agricultural commodities; and (3) farmers' need for the widest possible variety of risk management tools in today's highly competitive agricultural markets.

In December 1995, the Commission began a reconsideration of this important issue by hosting 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 in May of this year, 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 initial steps in that process are well underway. The June 9, 1997 Federal Register included an Advanced Notice of Proposed Rulemaking requesting comment on whether the Commission should propose rules to lift the ban and, if so, the appropriate conditions for doing so. The Notice included a list of some 30 questions and was subject to a 45-day comment period.

Also, the Commission held two public meetings to collect first-hand testimony from interested parties concerning the issues raised in the Federal Register Notice. The first of these meetings was held in Bloomington, Illinois, on July 10th, and the second in Memphis, Tennessee, on July 16th. These meetings enabled all five CFTC Commissioners to hear directly the views of a wide range of producers, processors, and other agribusiness interests.

In addition, on July 31, the National Cattlemen's Beef Association hosted an open forum at its Summer Conference in Reno, at which I and a staff member from the Commission's Division of Economic Analysis discussed the staff white paper and answered questions about agricultural trade options and the Federal Register Notice. The session gave cattlemen an opportunity to learn more about the Commission release and to express their views on agricultural trade options. Transcripts of all three of these public meetings were submitted for inclusion in the public comment file on the Advance Notice of Proposed Rulemaking.

Based upon an analysis of all the relevant information, including a review of the nearly 100 comments received and the recommendations of the agency's staff, the Commissioners will determine the appropriate action to take regarding agricultural trade options.

As the Commission and the agricultural community move through the deliberative process regarding agricultural trade options, I believe we need to view this issue not only in the context of today's environment, but also in light of the different business models that may be used in the future. To illustrate my point, let me tell you a quick story about one of the National Hockey League's all-time super star players. When a reporter asked Wayne Gretsky why he was so good, he replied, "other hockey players skate to where the puck is, I skate to where the puck is going to be."

Internal Controls as They Relate to Agribusiness Firms and Farmers

In this final segment of my three part presentation I will talk about the internal systems and controls agribusiness companies should have in place. I respectfully suggest that CPAs, working hand in hand with a company's board of directors, are the two key players in making sure internal systems and controls are implemented and work properly.

This topic is an appropriate follow-up to the prior segment concerning lifting the ban on agricultural trade options. The concerns posed by many of the shareholders in American Agriculture about agricultural trade options relate to the potential for abusive trading practices or elevator defaults involving those instruments. The best defense against abuses and defaults is effective internal controls. Do CPAs need to direct their attention to this area? To answer that question, I would refer you to the testimony of Mr. Clifton Duckworth at the December, 1995, CFTC Roundtable on agricultural trade options, Mr. Duckworth is a principal with the Illinois Ag Auditing Association located in Bloomington.

In his statement at the December Roundtable, held in Washington, DC. Mr. Duckworth noted that his group audits about 150 cooperatives each year, mostly in the grain area. Among other things, he expressed a serious concern, based on his experience with those audits, that there was a real need for elevators to improve their record keeping. Apparently, the National Grain and Feed Association shares that concern because in 1996 they published a "white paper" entitled "Hybrid Cash Grain Contracts, Assessing, Managing and Controlling Risk."

You may be familiar with the NGFA publication, so I will apologize up front to those of you who may have already read it because I am going to refer to it several times in this segment of my presentation. The white paper was prompted by problems encountered by farmers and elevators involving "hedge-to-arrive" and other hybrid cash grain contracts. However, the guidance it provides is broadly applicable to business practices in general. I personally think it is an excellent roadmap for elevators, bankers and accountants to follow as they deal with the reliability of an agribusiness company's financial record keeping system. Furthermore, it has been widely distributed for use by the grain industry and I see no reason for me to reinvent the wheel as I talk about internal controls.

To give you an idea of the range of critical issues covered in the NGFA white paper I will list them as they appear on page 28 of that publication.


Market Risk

I. Understanding, quantifying and managing price risk.

Counterparty Credit Risk

II. Why it exists and how to avoid losses.

Internal Systems and Controls

III. Systems needed to manage new contracts

Lending Issues

IV. How to manage the impact of hybrid cash contracts on credit lines

Customer Relations

V. Understanding the impact of hybrid cash contracts on customers

Legal and Regulatory Issues

Critical legal issues and status of federal and state regulations

Tax and Accounting Considerations

Unique issues relating to hybrid cash contracts

In pointing out these critical issues, the authors of the white paper state, "Effective risk management requires policies, practices, procedures and support systems that address each of the risks in the matrix." The "matrix" shows the level of relative risk both the buyer and the seller incur on each one of 12 different contracts. If you haven't already done so, I urge you to read the NGFA publication. I think it is a worthwhile guide you could use as part and parcel of the services you perform. To reinforce my point, let me give you some examples of what the white paper has to say on the subject of internal systems and controls.


In addition to market risk and counterparty credit risk, companies offering hybrid cash contracts also face administrative risk, defined here as the risk of loss occurring as a result of inadequate systems and controls, human error or management failure.

Companies should not engage in more complicated marketing strategies if their systems or internal controls are not sufficient to adequately confirm contracts, execute contracts, and provide enough information to monitor contract exposure and manage related risks. The degree of sophistication of systems and controls should be commensurate with the complexity of the contracts and the level of risk.

Fundamentals of effective internal controls are:

Oversight by senior management and/or board of directors;

Written policies, practices and procedures;

Separation of contracting and control responsibilities;

Integration and reconciliation of reports to the books;

Skilled and experienced personnel;

Timely reporting of financial position, exposure and risk; and

Technology commensurate with the level of risk.

Although you are familiar with the common controls for traditional cash contracts, I think it is important to quickly review NGFA's list before moving on to their coverage of options-based contracts.

Common controls for traditional cash contracts are:

I. Daily reconciliation of manual- and computer-generated position reports;

II. Daily review of new contracts for reasonableness;

III. Daily reconciliation of broker statements to position reports;

IV. Daily review of contract changes or deleted contracts;

V. Receipt of written trade confirmation from the counterparty;

VI. Periodic valuation of market positions (frequency depends on the size and risk profile of the positions).

Options-based contracts present these additional critical systems and control issues:

I. Identifying the option commitment(s) embedded in a cash contract to insure proper position reporting and hedging.

II. Periodic valuation of cash contract for financial reporting (requires valuation of embedded options).

III. Matching option commitments in cash contracts with hedges in the futures market to establish options risk.

IV. Contract amendments for expiring options.

V. Proper classification of funds received for option transactions from both the customer and the broker.

Additional comments in the "white paper" on options-based contracts are as follows:

One of the biggest concerns with options-based contracts is the possibility that options commitments embedded in the contract are not integrated into position reports. This could result in either a lack of hedging or improper hedging of the options risk. Effectively identifying options exposure and including the options commitment in a position report, as illustrated in the Market Risk section of this white paper, would significantly reduce this concern.

Systems and controls for options-based contracts depend upon the type of contract being considered. Special attention should be given to pricing mechanics. Identifying precisely when an obligation exists and at what point price risk is transferred are important factors in managing options risk.

This is good advice on how options-based contracts should be treated in the context of the exchange-traded options available today. It will become even more critical that these recommendations be adhered to rigorously if the Commission lifts the ban on agricultural trade options and we see a significant increase in the variety of option-related products and parties using them. The NGFA publication has an excellent section on internal controls for hybrid contracts. I don't have time to cover it today. Nonetheless, I commend it for your consideration.

Before I leave the white paper let me cover one more important point that the authors make. It has to do with the valuation process and I think you will agree with their statements, which are as follows:

Valuation Process

The valuation process is critical to risk identification and the integrity of profit and loss reporting. Valuations should be done by accounting/administrative personnel, not by trading personnel. For risk-management purposes, contract valuation should occur at least monthly, and more often, depending upon market volatility, potential dollar loss, position size and the capital position of the firm.

The valuation procedures should be part of a company's practices and procedures manual. They should cover all aspects of the valuation process, such as:

sources of input;


responsibilities; and

methods for valuing more complex or illiquid cash contracts.


In closing, let me leave you with two thoughts. First, there is a perception on the part of many people, a few CPAs included, that derivative instruments -- both exchange-traded futures and options and over-the-counter instruments, are perilous to one's financial well-being. In response to that fear, I think it is important to repeat a point of view recently expressed by Jerry L. Jordan, president of the Federal Reserve Bank of Cleveland. "Derivatives," he said, "don't add to the risks inherent in a modern financial system. They do, however, allow risk to be borne more efficiently."

Second, notwithstanding the media's delight at blaming derivatives for most of the financial train wrecks that have happened in the last decade, the truth of the matter is that the contracts themselves are not the culprit. The real reasons individuals or companies lost money in those situations stems from occasional fraud or, more frequently, the failure to have an adequate system in place to control and identify the exact amount of money they had at risk and do so on a timely basis.

In the new era for agriculture farmers and elevators will have to do a better job of managing their business risks. That's where you come in, because your services can make the difference between proper internal controls that enhance an individual's or company's financial integrity or deficient internal controls that become the weakest link in the risk management process and may cause irreparable financial harm. I know you are up to the task!

1. *Please note: the views expressed herein are those of the author and do not necessarily reflect those of the Commodity Futures Trading Commission or its staff.