"Trade Options on Agricultural Commodities"
National Council of Farmer Cooperatives
Grain and Oilseeds Committee
January 22, 1996
Sheraton Washington Hotel
Joseph B. Dial
Commodity Futures Trading Commission
I appreciate this opportunity to address NCFC's Grains and Oilseeds Committee. My topic -- agricultural trade options -- may seem a little obscure to some of you. I assure you, however, that this issue will assume ever increasing importance as NCFC and its members move to meet the economic and policy challenges facing American agriculture in the coming years.
My remarks will cover four areas: (1) an overview of the economic and public policy factors that make agricultural trade options so important; (2) a brief history of the statutory and regulatory treatment of ag trade options; (3) the current legal status of these instruments; and (4) a look ahead to what the future may hold for ag trade options.
Economic and Public Policy Factors
It appears that sweeping changes in federal farm policy may be made when the 1995 farm bill is finalized, though the extent to which the government safety net for farmers will be modified remains to be seen. If proposed major public policy changes are carried through, the governments's role in helping producers market their crops and manage the risk of farming will be phased out. Along with the prospect of less government intervention, there are several additional dynamics at work that are shaping the future of global agriculture.
First, a dramatic reduction of tariffs and non-tariff trade barriers is taking place through international trade agreements like the GATT and NAFTA accords. Second, rising incomes for the three billion people who live in China, India, the Pacific Rim and Latin America will increase 21st century demand for food and fiber. Third, in the future, U.S. bankers who make loans to specialists in production agriculture will place more emphasis on the need for their borrowers to provide a written marketing plan -- a plan that includes a risk management component. Finally, as agricultural commodity prices come to be driven more by free market supply and demand forces -- rather than politically motivated government programs -- there may be greater price volatility in the years to come.
As U.S. farmers and farmer cooperatives seek to survive and prosper in this new competitive environment, they will need access to the greatest possible variety of risk management tools. One potentially useful tool is agricultural trade options. However, as currently structured, an obscure provision of the CFTC's regulations prohibits trade options on certain agricultural commodities, including those grains and oilseeds traded on designated futures exchanges.
What exactly are "trade options" and why are they banned for agricultural commodities? Trade options are: (1) off-exchange commodity options; (2) that are offered to a producer, processor, commercial user of, or merchant handling, the commodity that is the subject of the option transaction; and (3) that are entered into solely for the purposes of the purchaser's business. Under CFTC Rule 32.4, trade options are exempt from Commission regulations (other than those forbidding unlawful representations and fraud). The trade option exemption does not, however, apply to those domestic agricultural commodities named in the Commodity Exchange Act -- including wheat, corn, oats, soybeans and soybean derivatives. Trade options in those commodities are banned. The history underlying this ban is long and complex.
History of the Legal and Regulatory Status of Trade Options
To put trade options into context historically, it is necessary to go back 75 years to the adoption of the Futures Trading Act of 1921. That law was intended to curb the disruptive activities of grain speculators on futures exchanges, as well as the proliferation of off-exchange "bucket shops."
Witnesses urged, however, that in bringing those activities under control Congress should not impede normal commercial forward contracting practices used by farmers to market their grains. Thus, the 1921 law included a provision excluding from regulation cash sales of grain for deferred shipment or delivery -- a provision that remains in the law to this day and has come to be known as the forward contracts exclusion.
When the Futures Trading Act of 1921 was declared unconstitutional on tax-related grounds, the forwards exclusion was incorporated into a successor statute, the Grain Futures Act of 1922. The next statutory revision, the Commodity Exchange Act of 1936, covered commodities in addition to grain, so the forwards exclusion was broadened to apply to sales of "any cash commodity" for deferred shipment or delivery. The 1936 Act also noted that speculative options trading had caused excessive price movements and severe market disruptions in the futures markets. Thus, it prohibited option trading -- both on- and off- exchange -- in all then-regulated commodities.
The next major rewrite of futures laws was the Commodity Futures Trading Commission Act of 1974, which created the CFTC. Congress gave the new agency authority to allow options -- both exchange-traded and off-exchange trade options -- in those commodities just coming under regulation for the first time. While this discretion did not extend to options on agricultural commodities -- those were still banned -- the Commission did use its new authority to set up a pilot program in non-agricultural exchange-traded options, and also to allow off-exchange trade options in non-agricultural commodities.
By 1982, Congress had come to believe that the abuses leading to the 1930s ag options ban were unlikely to recur in the more regulated 1980s, and that farmers might benefit from the additional marketing mechanism options could provide. Thus, the CFTC's 1982 reauthorization bill included authority to allow agricultural options -- both on- and off- exchange. The Commission moved quickly to add ag options to the exchange option pilot program. However, it left the ban on off-exchange agricultural trade options in place -- waiting to see how ag options would fare in exchange trading before turning its attention to the off-exchange environment.
Exchange-traded ag options were a resounding success -- providing a very useful tool for producers, processors and other market participants without engendering any significant market or trade practice abuses. Therefore, in 1991, after nearly eight years of experience with exchange-traded ag options, the Commission issued a proposal to lift the ban and allow off-exchange agricultural trade options. However, after carefully reviewing the 16 comment letters it received in response to the 1991 proposal, the Commission deferred action on that proposal until a later date.
Current Legal Status
That is where the situation remains today. Trade options on agricultural commodities are prohibited by CFTC regulations. Some would argue that the prohibition should remain in place -- that farmers are not sophisticated enough to understand and use new marketing strategies and need the benevolent hand of government to protect them from those who would take advantage of them. It has also been suggested that some country elevators lack the requisite experience to carry out the sometimes-intricate hedging techniques required to manage the risks inherent in the latest state-of-the-art contracts. And, it is asked, even if these elevators could handle the advanced hedging -- would their accounting systems accurately reflect the true risks they had taken on? -- would their banker be willing to finance new and untried marketing practices?
On the other hand, competitive pressures, coupled with the economic and policy changes I described earlier, are driving elevator operators and their producer customers to experiment with new risk management practices. For example, the new Area Yield futures and option contracts coming on line at the Chicago Board of Trade offer crop insurance firms, elevators and companies that sell fertilizer, chemicals, fuel and seed an innovative marketing mechanism to use in developing viable revenue insurance and/or revenue assurance contracts. These next generation risk management contracts would seek to provide farmers with a guaranteed level of revenue -- even if they had poor yields and received low prices at harvest. However, depending on how they are structured, these new contracts may face a serious obstacle in the form of the ag trade option prohibition.
Furthermore, as competition drives the development of these and other new and complex varieties of contracts, it is often difficult to tell whether, or to what extent, the trade option ban applies to a given instrument. The most recent definitive guidance issued by the Commission is a 1985 Interpretive Statement by the agency's Office of the General Counsel.
The Future of Agricultural Trade Options
Because I believe the Commission should not prohibit the private sector from reacting to market forces, I have worked for over a year to get the Commission to revisit the ag trade options issue. Those efforts finally led to a Roundtable Discussion on the Prohibition of Agricultural Trade Options, held in Washington on December 19, 1995. The Roundtable brought together a diverse group of commodity option and agricultural experts, regulators, academics, and market users to discuss all aspects of the ag trade option prohibition, including the potential costs versus benefits of lifting the prohibition. After thoroughly exploring the issues, the Roundtable participants expressed support for lifting the ban by a two-to-one margin.
The next step in the Commission's consideration of this issue will be for the staff of the Division of Economic Analysis to draft a release regarding lifting the ag trade options ban. After the Commission reviews, makes any appropriate changes, and approves this release, it would be published in the Federal Register for comment. The record developed from the release, along with other relevant information, such as the Roundtable proceedings, could then form the basis for a proposed rulemaking action to lift the agricultural trade options prohibition.