TESTIMONY OF
DAVID D. SPEARS, COMMISSIONER

ON BEHALF OF THE
COMMODITY FUTURES TRADING COMMISSION
CONCERNING AGRICULTURAL TRADE OPTIONS
BEFORE THE
COMMITTEE ON AGRICULTURE, NUTRITION AND FORESTRY
U.S. SENATE

MAY 5, 1999


Mr. Chairman and Members of the Committee:

I am pleased to appear on behalf of the Commodity Futures Trading Commission (Commission) today to discuss the Commission's pilot program for agricultural trade options. My testimony addresses the Commission's efforts to structure a pilot program to reintroduce trade options in certain agricultural commodities, explores possible impediments to the introduction and use of these instruments, identifies and analyzes issues raised by possible amendments to the pilot program's rules and details steps taken by the Commission to contribute to educating farmers about the potential usefulness of these instruments. The Commission appreciates the Committee's interest in this program and is confident that this hearing, along with the discussion of this issue at the recent derivatives roundtable hosted by this Committee, will assist the Commission in its further consideration of possible changes to the pilot program.

Agricultural Trade Options Defined

An option is a contract giving the purchaser of the option the right but not the obligation to make or take delivery of a specified commodity at a specified price (the strike price) within a specific time period. The option purchaser pays the option seller (or grantor) for this right. The cost of purchasing an option is known as the "premium." Option contracts are unique in that option purchasers are able to protect themselves, for the cost of the option premium, against adverse price movements while maintaining an upside profit potential. For example, a corn producer can protect against lower harvest time prices by purchasing put options with a given strike price. If the harvest time price of corn is below the strike price the producer can elect to exercise the option and earn the strike price on the sale of the corn. Alternatively, if prices are higher at harvest time the producer can choose to allow the option to expire and sell the corn at the higher spot price.

Trade options are off-exchange (OTC) options which are offered by a person having a reasonable basis to believe that the option is being offered to a commercial entity, where the option is entered into for purposes related to its business as such. As explained more fully below, until the Commission's interim final rules establishing a pilot program became effective on June 16, 1998, trade options on the agricultural commodities listed in the Commodity Exchange Act were prohibited. These commodities include, among others, wheat, cotton, rice, corn, soybeans and livestock. Trade options on other unlisted agricultural commodities and all nonagricultural commodities have been permitted under Commission rules subject only to anti-fraud, unlawful representation and prompt execution requirements. 17 CFR 32.4.

Statutory and Regulatory History of Option Trading

In 1936, responding to a history of large price movements and disruptions in the futures markets attributed to speculative trading in options, Congress completely prohibited the offer or sale of option contracts both on- and off- exchange in all commodities then under regulation.(1) This statutory bar continued to apply over the years only to the named agricultural commodities regulated under the 1936 Act. These commodities are referred to as the "enumerated" commodities. Any commodity not so enumerated, whether agricultural or not, was not subject to prohibition.(2)

In the years following passage of the 1936 Act, the off-exchange offer and sale of commodity options on the nonenumerated commodities was subject to fraud, abuse and sharp practice. That history was one of the factors leading to enactment of the Commodity Futures Trading Commission Act of 1974 (1974 Act), which substantially strengthened the Commodity Exchange Act and broadened its scope. The Act's scope was broadened by bringing all commodities under regulation for the first time. Congress accomplished this by adding to the list of enumerated commodities an expansive catchall definition of "commodity" which included all "services, rights or interests in which contracts for future delivery are presently or in the future dealt in."(3)

Under the 1974 amendments, the newly created Commodity Futures Trading Commission (CFTC) was vested with plenary authority to regulate the offer and sale of commodity options on the previously unregulated, nonenumerated commodities.(4) The Act's statutory prohibition on the offer and sale of options on the enumerated agricultural commodities was retained.

Shortly after its creation, the Commission promulgated a comprehensive regulatory framework applicable to off-exchange commodity option transactions in the nonenumerated commodities.(5) This comprehensive framework exempted "trade options" from most of the Act's provisions.(6) Trade options on nonenumerated commodities are exempt from all of the requirements applicable to commodity options except for a rule prohibiting certain representations and requiring prompt executions (Rule 32.8) and a rule prohibiting fraud (Rule 32.9).

In contrast to the regulatory framework for commodity options on the nonenumerated commodities, commodity options on the enumerated commodities--the domestic agricultural commodities listed in the Act--were prohibited, as a consequence of both the continuing statutory bar and Commission rule 32.2, 17 C.F.R. 32.2. This prohibition made no exceptions and applied to trade options as well as other options.

The attempt to create a regulatory framework to govern the offer and sale of off-exchange commodity options was unsuccessful. Because of continuing, persistent and widespread abuse and fraud in their offer and sale, the Commission in 1978 suspended all trading in commodity options except for trade options.(7) Congress later codified the Commission's options ban, establishing a general prohibition against commodity option transactions other than trade and dealer options.

The Commission subsequently permitted the introduction of exchange-traded options on the nonenumerated commodities by means of a three-year pilot program.(8) Based on that successful experience, Congress, in the Futures Trading Act of 1982, eliminated the statutory prohibition against options on the enumerated commodities, permitting the Commission to establish a similar pilot program to introduce exchange-traded options on those agricultural commodities.(9) The Commission did so in 1984 under essentially the same rules already applicable to options on all other commodities.(10) In proposing to permit exchange-traded options on the enumerated agricultural commodities, the Commission noted that section 4c(c) of the Act and Commission Rule 32.4 permitted trade options on the nonenumerated commodities and that "there may be possible benefits to commercials and to producers from the trading of these `trade' options in domestic agricultural commodities."(11) However, "in light of the lack of recent experience with agricultural options and because the trading of exchange-traded options is subject to more comprehensive oversight," the Commission concluded that "proceeding in a gradual fashion by initially permitting only exchange-traded agricultural options" was the prudent course.(12) Nevertheless, the Commission requested comment from the public concerning the advisability of permitting trade options between commercials on domestic agricultural commodities. Citing past abuses associated with off-exchange options, the consensus among commenters was that the Commission should proceed cautiously and retain the prohibition on such off-exchange transactions.

Since then, the Commission has reconsidered the issue of whether to remove the prohibition on the offer and sale of trade options on the enumerated commodities several times. In 1991, the Commission proposed deleting the prohibition on trade options on the enumerated commodities and including them under the same exemption applicable to all other commodities. 56 FR 43560 (September 3, 1991). The Commission never promulgated the proposed deletion as a final rule. On December 19, 1995, the Commission hosted a public roundtable to consider this issue once again and to provide a forum for members of the public to provide their views.

The Pilot Program for Agricultural Trade Options

Following the roundtable, the Commission directed its staff to study the issue and to report its recommendations. The Division forwarded the complete text of that study, entitled, "Policy Alternatives Relating to Agricultural Trade Options and Other Agricultural Risk-Shifting Contracts," to the Commission on May 14, 1997.(13) On June 9, 1997, the Commission published an Advance Notice of Proposed Rulemaking (Advance Notice) in the Federal Register seeking comment on whether it should propose rules to lift the prohibition on agricultural trade options on the enumerated agricultural commodities and if so subject to what conditions. 62 FR 31375. The Advance Notice posed 30 specific questions and included portions of the staff analysis of the issue. The seventy-six comments were almost evenly divided between those in favor of and those opposed to lifting the ban. In addition to the written comments, the Commission received oral and written statements during two public field meetings in July 1997 at which members of the public had an opportunity to address the Commission and to answer its questions regarding these issues. One of those meetings was held in Bloomington, Illinois, and the other was held in Memphis, Tennessee.

In November 1997, the Commission published proposed rules to establish a three-year pilot program to permit the offer or sale of trade options on the enumerated agricultural commodities. 62 FR 59624 (November 4, 1997). The proposal generated 441 comment letters to the Commission; commenters remained divided on whether the Commission should lift the prohibition on agricultural trade options. On June 16, 1998, the Commission's interim final rules establishing the pilot program became effective. 63 FR 18821 (April 16, 1998). In response to suggestions made in many of the comments, the interim final rules are more streamlined and less burdensome than proposed.

The pilot program rules were designed to provide a number of customer protections. These include requirements that option vendors be registered and that they adhere to minimum customer disclosure, financial, and recordkeeping safeguards. In addition, option vendors are required to have a system of internal controls and to report to the Commission on their option activity. The rules also include a number of provisions to discourage the use of trade options for speculative purposes. These include the requirement that agricultural trade options, if exercised, be physically delivered, and limitations on producers being the option grantor, including a prohibition on producers writing covered call options. These customer protection features are discussed more fully below:

a. Registration of Agricultural Trade Option Merchants (ATOM).

As noted in the interim final rules, "registration of commodity professionals is an important means by which the Commission polices the futures and option industry and is the primary mechanism for reassuring the public of the honesty and proficiency of futures professionals." 63 FR 18825. For this reason, the final rules require that any person offering or selling an agricultural trade option must register as an ATOM and likewise that its sales agents must register with the Commission. Moreover, by virtue of the registration requirement, customers have available to them under Section 14 of the Act the Commission's reparations program for resolving disputes arising under agricultural trade option contracts. The registration process for ATOMs and their sales agents is more streamlined than for other types of commodity professionals, however. For example, an ATOM's principals and sales agents are not required to submit fingerprints for background checks, need not take a qualifying proficiency exam and are not required to take yearly ethics courses. Instead, the ATOM's sales agents are required to complete six hours of instruction covering the economic functioning, and the legal requirements for the sale, of agricultural trade options and the registrant's responsibility to observe just and equitable principles of trade relating to such options. The Commission delegated responsibility for processing the registration applications to the National Futures Association (NFA), the self-regulatory organization which performs that function for all other Commission registrants.(14)

b. Disclosure.

The pilot program's rules require that the customer be provided two forms of risk disclosure--a statement of the general risks of agricultural trade options provided prior to the customer's first transaction and a second, "transaction-specific" disclosure giving information about the specific option contract being entered into.(15) In addition to providing customers with risk disclosure, the pilot program's rules also require that the option contract itself be in writing and contain a number of specified terms(16) and that ATOMs provide customers with information regarding their positions and accounts in a timely fashion and notify them of the expiration date of each option which will expire within the next month.(17)

c. Financial Safeguards.

The pilot program's rules require that to be registered, an ATOM must maintain a minimum net worth of $50,000. In addition, ATOMs must safeguard customer funds which have been paid up-front by holding them in segregation.(18) However, ATOMs may use up-front customer payments to purchase exchange-traded instruments as cover for the trade option transaction.(19)

d. Recordkeeping and Reporting.

The Commission adopted, as proposed, recordkeeping rules requiring agricultural trade option merchants to maintain full, complete, and systematic books and records. The maintenance of books and records is crucial to resolving customer complaints and to the Commission's ability to respond to complaints of customer abuse. In addition to the keeping of books and records, the final rules impose routine and special call reporting requirements.(20)

e. Limitations on Speculative Use.

The pilot program rules require that off-exchange agricultural options be exercised only by physical delivery of the commodity. However, the Commission made this provision more flexible by permitting an option's early termination (for a cash adjustment) by entry into a forward contract. The pilot program's rules also prohibit producers from writing or granting trade options, except when a call option is coupled with the purchase of a put option. These provisions "maintain a close relationship between the option transaction and the participant's cash market activities" and discourage the use of agricultural trade options as speculative vehicles.(21) 63 FR 18824.

The interim final rules permitting the offer or sale of agricultural trade options also include an exemption for high net-worth individuals or entities as well as relief for similar exchange-traded instruments. Individuals or entities that are commercials and have a net worth of at least $10 million are exempt from compliance with the protections discussed above.(22) Such high-net worth entities trading among themselves need only comply with the anti-fraud requirements which are applicable to trade options generally.

Status of the Pilot Program

To date, although a number of firms or entities have requested registration materials, no one has applied for registration as an ATOM since the interim rules went into effect in June 1998. Therefore, no agricultural trade option contracts legally may be offered, except pursuant to the rule's exemption provision. Because there are no reporting requirements for options offered pursuant to the exemption, the Commission cannot ascertain whether or to what extent such options are being traded between exempt entities. Reportedly, however, agricultural trade options are being offered to some extent pursuant to the exemption. On the other hand, the Commission is not aware of any trade options being offered or sold to producers of non-enumerated agricultural commodities, which are not subject to the pilot program's rules.

In light of the failure of any firm to register as an ATOM by the fall of 1998, Commission staff conducted a number of interviews to determine the reason. Trade sources interviewed by Commission staff indicated a variety of possible reasons for the lack of interest by potential ATOMs in offering agricultural trade options. A number of them suggested that development of a market in these instruments is likely to be demand driven and that low commodity prices have impeded development of demand.

Although options can be effective risk management tools to protect against rising or falling commodity prices, generally they cannot be used to enhance the sale price of a commodity or to lower the cost of obtaining it. For example, the ability of the producer to lock in a given price for corn (e.g., the cost of production) using an option will depend on the availability of options with such a strike price, taking into account the cost of the option. The availability of these options depends upon the current market price of corn as reflected by the supply and demand conditions for the commodity. If the supply of corn is high and/or the demand for corn is low, producers will only be able to obtain options with relatively low strike prices (or to the extent that high strike price options are available, they will pay concomitantly high premiums). Thus, depending on supply and demand conditions, no options may be available with a given strike price and premium combination that permit producers or other market participants to lock in a desired minimum or maximum price.

Since the time agricultural trade options were first permitted under the pilot program, agricultural prices generally have been depressed. As a result, producers likely would not be interested in using them because they would have resulted in the guarantee of a relatively low price. To the extent that producers may prefer to retain the cost of the option premium and remain unhedged during times of low prices, demand for these instruments is likely to remain slack until the current price situation improves.

However, some observers have suggested a different explanation for the lack of interest in these instruments. Various agricultural groups have voiced concern that the pilot program's rules are too onerous, thereby discouraging participation. Particular concerns have been raised that the registration, reporting and disclosure requirements are too burdensome and that certain restrictions on the form of options that producers may enter into limit their usefulness. These groups maintain that, if the regulatory requirements were relaxed, agricultural trade options on would be offered.

In lifting the ban on agricultural trade options, the Commission carefully weighed the potential benefits and costs associated with this action. The major benefits were seen as giving producers greater access to, and more flexibility in the design of, risk management contracts. The costs involved the increased potential for fraud or misuse of option contracts and increased systemic risk. The pilot program's rules attempted to strike an appropriate balance between the two. Nevertheless, the Commission recognizes that the pilot program is "an experiment" and has repeatedly noted that it "has not foreclosed reconsideration of any specific issue" during the pilot period. 63 FR 18823. Accordingly, the Commission has taken very seriously the views of those who maintain that amending the pilot program's rules will enhance their workability and lead to the introduction of trade options to the marketplace.

Commission's Receptivity to the Views of Agriculture

As a result of the Commission's expressed willingness to reconsider the pilot program's rules, I and Commission staff have engaged the agricultural community in an open and frank exploration of the benefits and costs of the pilot program rules. In light of the divergent viewpoints of those in the agricultural sector, the Commission determined that such a dialogue would be beneficial before proposing any specific amendments to the pilot program rules.

As a result, since the rules were promulgated, Commission staff and various Commissioners have met informally with representatives of agricultural interests on a number of occasions to gather their opinions and suggestions regarding the program. Initially, these meetings focused on exploring the existing rules and how the Commission would implement them. Subsequently, meetings with both national and state-level representatives focused on possible changes that might be appropriate.

The views of agricultural interests were also brought to the Commission's attention through more formal channels. For example, the Commission has had an opportunity to receive the views of agriculture through its Agricultural Advisory Committee (AAC), which I chair. The AAC, at its most recent meeting on April 21, 1999, heard presentations on the pilot program by representatives of the National Grain and Feed Association and the National Introducing Brokers Association. AAC members then engaged in a detailed discussion of various possible rule alternatives and the policy issues that such alternatives would raise. The pilot program was also a topic on the agenda of the AAC's August 12, 1998 meeting. The AAC's discussions are transcribed and are available to the Commission for its consideration.

Finally, the Commission and its staff also followed closely the testimony by participants at this Committee's roundtable to discuss futures, derivatives and related public policy issues held on February 25 and 26, 1999 and its hearings to examine crop insurance and risk management strategies held on March 10 and 17, 1999. We found the discussions to be informative and helpful to the Commission's efforts to gather opinions on this topic.

Areas of Possible Future Commission Consideration

The dialogue over the pilot option program rules has not resulted in a single industry-wide view or petition for rulemaking to the Commission. Nevertheless, that dialogue has been beneficial in highlighting a number of areas where there does appear to be some recognition that certain changes to the pilot program rules may be appropriate. Moreover, the dialogue has been beneficial in encouraging a number of producer organizations to develop a common approach to some of these issues. Specifically, nine farm organizations representing a broad cross-section of production agriculture submitted to the Commission their common views on these issues by letter dated April 23, 1999.

Without prejudging any specific issue, some possible areas have been suggested for Commission reconsideration:

a. Registration.

Although registration of ATOMs, as discussed above, is more streamlined than for other Commission registrants, some have suggested that the Commission establish a simple notification process in lieu of registration. Consideration of this alternative would need to take into account the possible loss of certain features associated with registration, including the statutory right of those who deal with Commission registrants to use reparations proceedings and an assurance that registrants meet a minimum level of probity and competence. Commission reparations proceedings offer the customers of registrants an inexpensive, expert forum for resolving disputes arising out of a violation of the Act or Commission rules. Some grain elevators are of the view that the availability of this dispute resolution forum increases their risk of litigation.

A related issue is the pilot program's delegation of the registration processing function to NFA. A possible alternative to this arrangement that has been suggested would be for the Commission itself to process these registration applications. If this change were implemented, it would limit access by a second regulatory authority to an ATOM's books and records, but would entail some additional cost to the taxpayer.

b. Disclosure.

There have also been a number of suggested alternatives to the disclosure requirements. As discussed above, the pilot program requires ATOMs to provide specific risk disclosures prior to each transaction in addition to a general risk disclosure statement. One suggestion has been to provide more information in the general disclosure and not to require transaction-specific disclosures. This would reduce the obligation on an ATOM when entering into a series of transactions with an established customer, but would provide the customer with less specific information.

c. Physical Delivery.

The requirement that the option be exercised only by physical delivery effectively limits the size of the trade option position to the size of the crop grown by producers and the volume of trade carried by elevators and dealers. Doing so discourages excessive leverage in trade option positions, ensures that trade option transactions are between commercials in normal marketing channels and reduces the likelihood they will be used for speculation.

One proposal is to permit cash settlement of the trade option contract.(23) Allowing cash settlement at termination of the contract would enable producers or dealers to capture the gains from the contract while delivering their underlying commodity to some more convenient or otherwise advantageous location. Allowing early termination of the contract through offset would allow producers and dealers further flexibility in entering and exiting positions. The greater the flexibility permitted by the rules, however, the easier it would be to use the instruments for speculation.

A related issue is whether producers should be prohibited from writing call options. The purchaser of an option assumes limited risk. The most that he or she can lose is the amount of the option premium. The writer of an option, however, assumes unlimited risk in return for receiving that option premium. Presumably, agricultural producers could write "covered calls," meaning that the price risk created by the option is hedged or covered by the farmer's crop or livestock, which would similarly rise in price. Some have suggested that permitting producers to write covered calls allows them to enhance their revenues by generating premium income. However, this strategy creates the risk that the cover might be inadequate due to overwriting or to crop failure. In such a case, the producer could face potentially unlimited price risk from the option. This may also leave the ATOM vulnerable to substantial credit risk due to customer defaults.(24) Moreover, simply writing a call option leaves the producer exposed to downside price risk.

d. The Exemption Level.

Certain "sophisticated entities" are exempt from the agricultural trade option rules. Commercial entities with a net worth of $10 million or more qualify for the exemption. Although high net worth is no guarantee of financial sophistication, it is an established standard used in other statutes and rules to serve as a proxy for sophistication or the ability to hire sophisticated advice or counsel.

Concern has been expressed that the current level of net worth required to qualify for exemption is too high. However, as the Commission noted in adopting the interim final rules:

The concern is that a relatively large number of individuals engaged in agriculture might meet these financial criteria based not so much on their investment sophistication and ability to gather and manage a sizable asset portfolio, but rather simply reflecting the need to acquire a threshold level of land and machinery to operate successfully a farm or agricultural enterprise.

63 FR 18829. In addition, because farm assets are typically less liquid than financial securities, lowering the exemption level might increase participation, but would do so at the potential risk of increasing participation by less credit-worthy counterparties.

Moreover, some have expressed concern that lowering the exemption level "will create a competitive inequity across the merchandising sector.: A lower exemptive level potentially could favor larger firms and fail to attract sufficient volume in instruments offered pursuant to the pilot program rules to constitute a test of their workability.

e. Possible streamlining

Other changes to the pilot program have been suggested as a means of reducing the paperwork associated with the rules. For example, the pilot program requires written execution of contracts. It has been suggested that oral contracting should be permitted with a written confirmation. Such contracting practices follow state law patterns and are used for forward contracts. This practice could be incorporated into the pilot program rules, but in contrast to forward contracts, may be less useful in the formation of option contracts, particularly where the ATOM collects the option premium up front. A related suggestion is to permit oral as well as written notice to customers in the month before an option expires . Similarly, permitting an oral rather than a written response to customer inquiries for account information might well be a means of reducing paperwork burdens that the Commission may wish to consider. Finally, it has been suggested that the cost and burden of submitting routine reports to the Commission should be reduced. The Commission could reconsider whether less than quarterly reporting would provide it with sufficient information relating to market activity. For example, we could consider a single, annual report as a means of reducing the cost and burden of producing required reports.

An additional suggestion to cut administrative costs would be to permit ATOMs to retain in nonsegregated accounts a small amount of customer funds representing commissions and mark-ups. This would enable ATOMS to use the remainder of the option's purchase price to cover the transaction with an exchange-traded instrument, as permitted currently, without having to maintain a segregated account for the safekeeping of only that portion of the purchase price constituting the ATOM's mark-up.

As the above discussion illustrates, the dialogue between the Commission and agricultural groups has resulted in a number of general and specific suggestions for rule amendments which merit serious consideration.

Education

A third factor affecting whether agricultural trade options will become available and be used is a lack of familiarity among many in the agricultural sector regarding risk management techniques generally and agricultural trade options, specifically. Until the pilot program rules permitted its reintroduction, off-exchange option trading in these agricultural commodities had been prohibited for well over a half-century. Widespread educational efforts will be necessary to give producers a better understanding of what the instruments are and how to use them safely.

To this end, the Commission recently released three educational pamphlets on agricultural trade options prepared by its Division of Economic Analysis. (See copies attached.) These pamphlets provide an overview of agricultural trade options and the pilot program rules for trading them. The first of these brochures, entitled "Agricultural Trade Options -- What Agricultural Producers Need to Know," was issued in December 1998. This brochure acquaints agricultural producers with how they can use agricultural trade options to manage risk. The second and third brochures summarize how to become an agricultural trade option merchant and provide general information to lenders and extension agents, respectively.(25)

The Commission printed and distributed 3,000 copies of each of these pamphlets. One producer organization requested a copy of the producer brochure for each of its 30,000 members. Budgetary constraints prevented the Commission from filling that request, although the Commission made galleys available for redistribution by others. The Commission also has made these brochures available through its web site at http://www.cftc.gov (Reports and Publications--Popular Brochures On-Line).

In addition, the Commission has been active in efforts to educate producers generally about risk-management strategies. As provided by the Federal Agricultural Improvement and Reform Act of 1996, the Commission has been actively consulting in the implementation of that Act's broad risk management education (RME) mandate to the United States Department of Agriculture. Although futures and option contracts are but two of the many risk management tools included in USDA's education initiative, the Commission has participated in these efforts enthusiastically and is a member of the four-person steering committee set up at USDA to direct the RME effort. I represent the Commission on that steering committee and serve along with the administrators of USDA's Risk Management Agency, Cooperative Research, Education and Extension Service and Outreach Office. The Commission's experience to date as a member of that committee has been highly collaborative in nature and has helped provide farmers with access to the knowledge necessary to utilize a wide range of risk management techniques.

The Commission also makes available information on risk management issues on an on-going basis through its Office of Public Affairs, which provides informational brochures, background reports, and specific information to producers as well as to the press and members of the public. In furtherance of these efforts, the Commission established a web site on the Internet in October 1995 and has continued to add information of educational value to market users and potential market users. Among the materials that may be accessed on the CFTC home page are speeches, press releases, commitments of traders reports and other economic reports, economic studies, informational brochures, information on the CFTC reparations program (including information on filing a claim), and enforcement information. The site also contains links to other futures related sites, including the home pages of domestic and foreign futures exchanges.

Information on risk management is vital, and the Commission is committed to continuation of its education activities. The Commission is also committed to making its pilot program for reintroducing agricultural trade options a success. To that end, the Commission will continue to monitor closely developments associated with the offer or sale of these instruments and to consult with the agriculture community throughout the term of the pilot program.

Finally, I am pleased to announce that Commission staff will be preparing recommendations for revising the pilot program rules for Commission consideration. The Commission is committed to working with industry participants to modify the current rules in order to make the program more useable. We recognize that a successful program will give agricultural producers another risk-shifting alternative in an era when downside price protection is of utmost importance.


1 Commodity Exchange Act of 1936, Public Law No. 74-675, 49 Stat. 1491 (1936). See, H. Rep. No. 421, 74th Cong., 1st Sess. 1,2 (1934); H. Rep. No. 1551, 72d Cong., 1st Sess. 3 (1932).

2 Examples of nonenumerated commodities include coffee, sugar, gold, and foreign currencies. Before 1974, the Act covered only those commodities enumerated by name. The 1936 Act regulated transactions in wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghum, mill feeds, butter, eggs and solanum tuberosum (Irish potatoes). Act of June 15, 1936, Public Law No. 74-675, 49 Stat. 1491 (1936). Subsequent amendments to the Act added additional agricultural commodities to the list of enumerated commodities. Wool tops were added in 1938. Commodity Exchange Act Amendment of 1938, Public Law No. 471, 52 Stat. 205 (1938). Fats and oils, cottonseed meal, cottonseed, peanuts, soybeans and soybean meal were added in 1940. Commodity Exchange Act Amendment of 1940, Public Law No. 818, 54 Stat. 1059 (1940). Livestock, livestock products and frozen concentrated orange juice were added in 1968. Commodity Exchange Act Amendment of 1968, Public Law No. 90-258, 82 Stat. 26 (1968) (livestock and livestock products); Act of July 23, 1968, Public Law No. 90-418, 82 Stat. 413 (1968) (frozen concentrated orange juice). Trading in onion futures on United States exchanges was prohibited in 1958. Commodity Exchange Act Amendment of 1958, Public Law No. 85-839, 72 Stat. 1013 (1958).

3 The definition of commodity is currently codified in section 1a(3) of the Act.

4 Section 4c(b) of the Act provides that no person "shall offer to enter into, enter into or confirm the execution of, any transaction involving any commodity regulated under this Act" which is in the nature of an option "contrary to any rule, regulation, or order of the Commission prohibiting any such transaction or allowing any such transaction under such terms and conditions as the Commission shall prescribe." 7 U.S.C. 6c(b).

5 17 CFR Part 32. See, 41 FR 51808 (Nov. 24, 1976) (Adoption of Rules Concerning Regulation and Fraud in Connection with Commodity Option Transactions. See also, 41 FR 7774 (Feb. 20, 1976) (Notice of Proposed Rules on Regulation of Commodity Option Transactions); 41 FR 44560 (Oct. 8, 1976) (Notice of Proposed Regulation of Commodity Options). Options were not traded on futures exchanges at that time.

6 As noted above, trade options are defined as off-exchange options "offered by a person having a reasonable basis to believe that the option is offered to the categories of commercial users specified in the rule, where such commercial user is offered or enters into the transaction solely for purposes related to its business as such." 41 FR at 51815; Rule 32.4(a) (1976). This exemption was promulgated based upon an understanding that commercials had sufficient information concerning commodity markets as to transactions related to their business as such, so that application of the full range of regulatory requirements was unnecessary for business-related transactions in options on the nonenumerated commodities. See, 41 FR 44563, "Report of the Advisory Committee on Definition and Regulation of Market Instruments," Appendix A-4, p. 7 (Jan.22, 1976).

7 43 FR 16153 (April 17, 1978). Subsequently, the Commission also exempted so-called dealer options from the general suspension of transactions in commodity options. 43 FR 23704 (June 1, 1978).

8 46 FR 54500 (Nov. 3, 1981).

9 Public Law No. 97-444, 96 Stat. 2294, 2301 (1983).

10 49 FR 2752 (January 23, 1984).

11 48 FR 46797, 46800 (October 14, 1983) (footnote omitted).

12 Id.

13 The study is available through the Commission's Internet site at http://www.cftc.gov/ag8.htm.

14 In November 1998, the Commission also authorized NFA to take certain adverse actions concerning these categories of registrants on its behalf.

15 Where the full premium or purchase price of the option is not collected up front, or where through amendments to the option contract it is possible to lose more than the amount of the initial premium, the provisions of the transaction-specific disclosure statement must reveal the worst possible financial outcome that could be suffered by the customer.

16 In particular, the contract must include terms specifying the procedure for exercise of the option contract, including the expiration date and latest time on that date for exercise; the total quantity of the commodity underlying the contract; the quality or grade of commodity to be delivered if the contract is exercised and any adjustments to price for deviations from stated quality or grade, or the range [there]of, and a statement of the method for calculating such adjustments; listing of elements comprising the purchase price to be charged, including the premium, mark-ups on the premium, costs, fees and other charges; the strike price(s) of the option contract; additional costs, if any, which may be incurred if the commodity option is exercised; and delivery location, if the contract is exercised.

17 These requirements are in lieu of a monthly account statement. Many commenters took the view that requiring ATOMs to provide a monthly account statement would impose a costly informational burden for a questionable benefit.

18 The segregation requirement both discourages a business in financial difficulty from writing options to generate immediate cash and is a means of better safeguarding customer funds.

19 An ATOM is also required to be audited on a yearly basis in accordance with generally accepted accounting principles and to file a copy of its certified financial statements with the Commission within 90 days after the close of its fiscal year. An ATOM must report immediately to the Commission if its net worth falls below the $50,000 minimum net worth threshold and must notify the Commission of any material inadequacies discovered by a certified public accountant in its internal controls.

20 Routine reports are required for general market surveillance purposes, to permit the Commission to construct a picture of the market and to evaluate the impact of activity in the trade option market on the cash and exchange-traded markets. Special calls are a reporting device used by the Commission for obtaining information only when needed.

21 As the Commission noted in adopting this provision, the physical delivery requirement does not preclude development of many types of innovative option contracts. For example, consistent with the rule's requirements, revenue-type option contracts could be offered by referencing the yield on a designated number of acres, based either on the producer's actual yield or a reported average yield, thereby providing a minimum return to a producer per acre.

22 A party may also qualify for the exemption on the strength of a guarantee by an affiliate.

23 The pilot program rules currently permit a degree of flexibility through the early termination of the trade options if it is rolled into a forward contract. This enables the option buyer to regain some of the option's time value and to lock-in a final delivery price for the crop.

24 As noted above, one means of covered call writing is permitted under the pilot program rules. This is the use of a mini-max option spread (also known as a "fence" or "window"). In this contract, a producer exchanges the upside gain of a price increase by selling a call in return for insuring against a price decline by using the revenue from the sold call to buy a put. If the strike price on the call is above that on the put, then there is a price range within which the producer bears the price risk. In this context, allowing producers to write call options enables them to reduce the cost of buying a put to insure against a price decline.

25 These pamphlets, which were published in February, 1999 are entitled, "How to become an Agricultural Trade Options Merchant," and "Agricultural Trade Options - Information for Lenders and Extension Agents."