TESTIMONY OF JOHN E. TULL, JR.
COMMODITY FUTURES TRADING COMMISSION
BEFORE THE SUBCOMMITTEE ON RISK MANAGEMENT
AND SPECIALTY CROPS AND THE
SUBCOMMITTEE ON GENERAL FARM COMMODITIES OF THE
COMMITTEE ON AGRICULTURE
UNITED STATES HOUSE OF REPRESENTATIVES
JULY 24, 1996
Congressman Ewing, Congressman Barrett and members of the Subcommittees:
I am pleased to represent the Commodity Futures Trading Commission ("Commission" or "CFTC") at today's hearing on hedge-to-arrive contracts. I commend you for calling a hearing on this timely and important subject, which has been of great concern to the CFTC. With me today are Mr. David Merrill, my Executive Assistant, and Mr. Paul Architzel, Chief Counsel of the Division of Economic Analysis.
Profound changes are occurring in agriculture today which the members of both your subcommittees understand well. New and untested ways of doing business are evolving in response to changes caused by the restructuring of federal agricultural support programs. The CFTC supports innovations that will help farmers to reduce risk. However, those concerned must be sure that new instruments developed to do so are legal, prudent, and fully understood by those using them so that they help, rather than harm, the agricultural community. One example of a new instrument appearing to have harmed some of its users through misuse is the contracts we are here to talk about today--Hedge-To-Arrive ("HTA") contracts.
CFTC EXPERIENCE WITH HTA CONTRACTS Over the past year, the CFTC has received numerous inquiries about various commodity contracts, primarily for corn, between agricultural producers and merchants. These contracts are known by various names, including "HTA," "Flex HTA," and "HTA Plus." One of the first things we learned was that these transactions were by no means identical. The particular contracts we heard about had names, terms, and usage that varied widely among regions of the country, and even from one elevator to the next within a region. It appeared that these contracts were centered in various parts of the nation's corn belt -- particularly in Iowa, Nebraska, Minnesota, Michigan, and Ohio.
In some cases, the way a particular HTA contract actually operated was not apparent from the face of the contract. It also appears that the course of dealing surrounding some HTA contracts evolved over time, with significant changes occurring last fall. Due to the great variability of these contracts and the potential impact on the agricultural community of any action the CFTC might take, the CFTC has adopted a careful, balanced approach in this area.
GENERAL OVERVIEW OF HTA CONTRACTS
To give you a general overview, in the most basic type of HTA contract, a producer agrees to deliver a specified quantity and grade of commodity by a specified date to an elevator. Delivery of the commodity is typically mandatory absent an intervening event such as a crop failure. The contract sets a final price to be paid for the commodity by referencing the current price of the exchange futures contract month maturing at around the same time, or after the time, that delivery is to be made.
A local basis, which is the difference between the spot price of a commodity and the price of the nearest futures contract for the same or a related commodity, is not established when the contract is entered into, but may be selected by the producer at any point in time up to the delivery period of the HTA. The value of the basis, when established, is equal to the current basis quoted by the elevator for the delivery period of the contract. By the specified delivery date, the producer delivers the grain and receives the contract price, which equals the original contract price plus or minus the local basis adjustment.
EVOLUTION OF HTA CONTRACTS
Over time, more complex terms appear to have been added to the HTA contracts. For example, the terms of the contract may have allowed the producer to delay delivery and final pricing on the contract by specifying or "rolling" to a new futures contract month reference price. If a new reference price was specified, the price of the contract was adjusted by adding the difference between the price of the newly-referenced futures contract month and the formerly-referenced futures contract month to the old contract price, less any "roll charges" or fees specified in the contract. Furthermore, the contract may have set a reference price to be paid for the commodity that was based on a futures contract month that would expire before the grain was actually available for delivery.
Last fall, the delivery of commodities under some HTA contracts apparently changed when some producers were allowed to deliver grain at the prevailing spot price, which was higher than the previously agreed upon HTA contract price. Delivery under those HTA contracts was simply delayed by rolling forward the delivery period and the reference price. Thus, producers took advantage of higher spot prices and rolled forward their obligation to deliver. Some producers, noting the relatively favorable prices, sought to sell several years' future production through HTAs.
Typically, although many such producers had already sold their entire 1996 production, it appears that some HTA contracts were priced with reference to the March 1996 futures contract, with the understanding of producers that they could continue to roll the delivery date until a future harvest. Thus, they could deliver the crop in the fall of 1996, or even later if necessary, until the delivery obligation was fulfilled. To hedge their risk under HTAs against the original contract purchases, the elevators took short positions in exchange-traded futures.
IMPACT OF ROLLED DELIVERY ON PARTIES TO HTA CONTRACTS
Although the potential for such HTA contracts to be uneconomic was inherent in their design, elevators and producers apparently felt comfortable in extending delivery under their HTA contracts, based on the assumption that the historical price relationships of recent years between various months and crop years would continue. Normally, the out-month futures price within a crop year is higher than the near futures price and the cash price. This relationship reflects the "cost of carry." However, due to market fundamentals, the markets have not acted as anticipated: beginning in March 1996, the 1996 old-crop futures prices rose to levels well above those for the fall harvest and remained there. An unusually large price inversion developed that made the current value of the commodity higher than the expected value at harvest in the fall. Apparently, producers who had planned to roll their delivery obligations forward found that it cost them a lot more than they had anticipated based on historical price relationships.
Both producers and elevators were placed in a difficult financial situation. Some producers with HTA contracts faced the prospect of receiving much reduced prices for this fall's production. At the same time, due to rising grain prices, elevators were required to post substantial amounts of margin to maintain their short positions in exchange-traded futures.
As you know from press reports, both producers and elevators have sought redress through private litigation. Reportedly, lawsuits have been filed by producers seeking to invalidate their HTA contracts, while some elevators have sued to enforce the terms of particular HTA contracts.
THE FORWARD CONTRACT EXCLUSION
Part of the legal controversy surrounding these HTAs concerns whether or not they are "forward contracts" within the meaning of the Commodity Exchange Act ("Act"). Although they are contracts in which delivery is to occur in the future, true forward contracts are excluded from regulation by the Commission under a self-executing exclusion from the Act called the forward contract exclusion. 7 U.S.C. 1a(11)(1994). This exclusion has been a part of the law since 1921. Because of this exclusion, forward contracts are not required to be traded on a futures exchange and, therefore, are generally governed by state and not federal law. By contrast, unless otherwise exempted, all futures contracts and options on corn, wheat, soybeans, and the other commodities enumerated in the Act are required to be traded on exchanges that have been designated by the Commission as contract markets.
In determining whether a contract or transaction falls within the forward contract exclusion or constitutes a futures contract which must be traded on an exchange, the courts and the Commission look at the entire transaction and consider the terms of the contract as well as the practices of the parties. In this regard, the Commission and the courts have agreed that a transaction must be viewed as a whole with a critical eye toward its underlying purpose. Due to the many differences among various HTA contracts reviewed by the CFTC, determinations on the nature of particular HTA contracts must be made individually on the facts of each particular case.
CFTC ACTION IN RESPONSE TO THE HTA SITUATION
Since the evolution of HTA contracts into transactions possibly raising questions under the Act, the Commission has been looking at these instruments and considering: whether certain of these HTAs may be illegal off-exchange futures or options contracts; whether fraud was involved in their marketing; and whether certain parties offering these contracts should have been registered under the Act. Due to the wide variation among contracts, the Commission has acted carefully but diligently in surveying this situation. Also, the recent period of unprecedented market volatility has heightened the Commission's desire to provide guidance in a manner that was not unnecessarily disruptive to the grain markets.
In the past, Commission staff has responded to questions that have arisen concerning whether novel practices or contracts that the agricultural sector wished to engage in qualified for the forward contract exclusion by issuing interpretive statements or no-action letters. This advice remains available to the agricultural community.
However, Commission staff also concluded that certain additional actions might assist parties to HTA contracts in addressing their individual circumstances currently and in the future. Therefore, on May 15, 1996, Commission staff issued two statements relating to HTAs -- a Statement of Policy and a Statement of Guidance. In providing these statements, the staff did not express any opinion on the validity or legality of any individual contract. Such determinations must be based on each HTA contract's specific facts and circumstances.
The Statement of Policy was issued because Commission staff believed that some people may have concluded, based upon earlier court and staff guidance, that failure to deliver on a particular agricultural contract would determine whether the transaction was within the forward contract exclusion. Commission staff issued the Statement of Policy to provide comfort to parties wishing to enter into a separate agreement to resolve their obligations under HTA contracts. Thus, they could be assured that the fact they may agree to settle, unwind, or otherwise restructure their HTA contracts, held as of May 15, by employing some form of cash payment between the parties, would not be used as evidence that their existing contracts were illegal off-exchange futures contracts.
The Statement of Policy's goal was to provide certainty to the agricultural community -- producers and elevators alike -- that cash payments may be part of a separately negotiated agreement used to unwind or restructure existing HTA contracts, of whatever variety, without creating a violation of the Act. In taking this stance, the Commission staff's goal was to remove any potential to view the Act as a barrier to those parties seeking to work out a resolution of existing HTA contracts using some form of cash payment. In so doing, the Commission has been careful not to take the side of either party to HTA contracts, or in any way to suggest that existing HTA contracts must be unwound or restructured using cash payments. Rather, the staff's Policy Statement is intended to offer fair and even-handed assistance to parties on both sides of HTA contracts, where those contracts have been entered into in good faith, by suggesting a possible method that may be used to resolve differences between them.
To provide some prospective assistance to the agricultural community, the Statement of Guidance details those elements of future HTA contracts that the staff finds to be necessary in order for an instrument to adhere to principles of prudent risk reduction. In particular, the Statement of Guidance advises that prudent HTA contracts should:
1. Require mandatory delivery, absent an intervening event, such as a crop failure, of a specified quantity and grade of grain at a specified location and reference price by a specified date within the crop- year during which the crop is harvested;
2. Provide for delivery of a quantity that is reasonably related to the producer's annual production, not committed elsewhere, and normally available for merchandizing and at a location whereby delivery can be made by the producer under normal merchandizing practices;
3. Specify a delivery date and futures contract month reference price that coincides with the crop-year during which the grain will be harvested; and
4. Permit, where such contracts include provisions allowing the "rolling" of reference prices, that reference prices only be rolled sequentially from a nearby to a more deferred futures contract month in the same crop-year within which the grain is, or will be, harvested, to reflect the production and inventory- carrying nature of the cash position.
EVENTS FOLLOWING THE ISSUANCE OF THE MAY 15 STATEMENTS
Following the issuance of the May 15 Statements, the Commission and its staff have worked diligently to inform the public of the contents of the Statements and to provide them with accurate information about HTA contracts. In this regard, Commissioners and staff have participated in a number of public meetings across the country designed to clarify the scope and meaning of the staff Statements and to provide background information on the current market situation and its implications for HTA contracts.
In addition, Commission staff has responded to a large number of requests for information and comments on HTA contracts from individuals directly affected by these instruments. During the spring, and particularly after the May 15 releases, the Commission's Office of Public Information fielded, on average, over 25 calls per day from affected individuals. That number has declined over the ensuing period to an average of two or fewer calls per day.
CFTC OVERSIGHT OF ENTITIES WITH POTENTIAL HTA-RELATED EXPOSURE
Aside from the effects felt by parties to HTA contracts, the CFTC has been concerned about the potential impact of these instruments on related persons such as futures commission merchants ("FCMs") and exchange clearing members who carry futures and option positions in corn futures for large traders with financial exposure due to HTAs. As the problems arising from HTAs came to light, Commission staff and the Chicago Board of Trade ("CBT") financial oversight staff identified the FCMs and clearing members who carried positions related to HTA contracts to assess the size of their exposure and the potential effect of this exposure on the futures and options markets.
As part of this oversight, Commission staff contacted certain elevators and cooperatives with possible exposure. The Commission shared with CBT staff the information obtained through these contacts. Based upon these contacts, CFTC staff has concluded that, at this time, overall futures market exposure related to HTA contracts is not large enough to raise immediate concerns about systemic risk or immediate concerns about the viability of any particular FCM or exchange clearing member. However, the CFTC has advised individual futures firms and market participants to pay close attention to their own risk analyses and exposure due to HTA-related futures positions.
In addition, the CFTC notified other regulatory authorities concerning these issues and offered to assist them in assessing any potential effects of HTA contracts on the entities they regulate. In particular, the Commission has shared information with banking regulators and farm credit agencies and with the member agencies of the President's Working Group on Financial Markets.
In sum, our oversight of firms with HTA-related exposure has been a Commission priority throughout this period and will remain so until HTA-related risk has subsided.
CFTC HEIGHTENED MARKET SURVEILLANCE DURING THIS PERIOD
Because of recent increased volatility in many agricultural markets due to tight supply conditions, since December 1995 the Commission has been conducting intense market surveillance of the grain markets. Our market surveillance consists of general oversight of the futures and option markets and, when warranted, more in-depth oversight of individual positions of large traders where those positions may pose a threat to orderly futures markets. Surveillance relating to HTA contracts, therefore, has been just one part of the CFTC's larger heightened surveillance effort.
In particular, the Commission was concerned about the potential price impact on the July corn contract as exchange- traded futures positions used to hedge HTA contracts were offset or rolled forward. To address this concern, the surveillance staff first sought to establish the extent to which large traders held short July corn futures positions as hedges against HTA contracts. Staff established that, for the most part, HTAs were concentrated in particular areas of the corn belt. They found that, while the exposures and positions might be large, relatively, within particular localities, the size of futures positions related to HTA contracts was far less significant than had been reported initially in the press. Second, Commission staff turned its attention to analyzing the potential impact, if any, that HTA-related futures and options positions might have on the unwinding of the July 1996 corn futures contract.
During this period of heightened market surveillance, the Commission, in its weekly surveillance meetings and in additional special meetings, was briefed on the status of the July corn futures liquidation, and on the positions of those market participants and selected clearing firms with significant HTA- related exposure. In this way, the Commission has tracked the trading activity of market participants with HTA-related exposure as their positions in the July corn contract were unwound. The Commission is pleased to report that the July corn contract expired on July 22 without incident and that no extraordinary actions were required of the CFTC in monitoring the close of trading. The Commission will continue its heightened surveillance of these markets throughout the remainder of this crop year or as long as necessary.
OTHER CFTC RESPONSES TO THE HTA SITUATION
In addition to these actions, the Commission is aggressively investigating several situations involving hedge-to-arrive contracts. Our Divisions of Economic Analysis and Enforcement have been looking into the HTA situation. Among the issues that they are evaluating are: (1) whether some of these contracts may be illegal off-exchange futures or agricultural trade options; (2) whether certain participants are required to be registered as FCMs, commodity trading advisors, associated persons, or introducing brokers; and (3) whether some persons may have committed fraud in the marketing or sales of HTA contracts.
The Commission will take appropriate action to address any violations of the law that it may uncover, and it is pursuing its inquiries with resolve, dispatch, and care. Any illegal conduct will not be tolerated.
However, any particular Commission enforcement action may not assist parties currently subject to other HTA contracts in sorting out liability among themselves, given the widely varying forms of, and courses of dealing under, these contracts. Any Commission enforcement action relating to HTA contracts would affect only the legality of the particular instrument and the conduct of the specific parties at issue in the proceeding. Private conflicts arising from those or other contracts would need to be resolved by the parties to the contract through negotiation or, ultimately, through litigation, in which case contract law and equitable principles based on the parties' often long-term course of dealing would govern.
As when the staff issued guidance on May 15, the CFTC has proceeded carefully in this area with full consideration of the possible impact any pronouncement or action might have on an already volatile situation. The Commission has consistently encouraged, and today continues to encourage, parties to HTA contracts to work out their differences by mutual agreement. The May 15 Statements continue to offer parties to HTA contracts certainty and guidance in exiting these instruments through mutual agreement.
OTHER CASH AND FUTURES MARKETS
The HTA situation and the Commission's response to it highlight the interrelationship between physical commodity markets and futures trading. The offer and sale of HTA contracts by those in the physical grain markets have raised the CFTC's concern with regard to both the contracts themselves and their possible collateral effects on the exchange-traded futures market. Accordingly, in carrying out its functions, the Commission remains mindful that, although these are separate markets, events in the physical markets can have direct effects on the futures markets.
The same lesson, of the interrelationship between futures and physicals markets, is illustrated by recent events surrounding the copper markets. Throughout the same period of heightened surveillance of the grain markets, the Commission has undertaken similar close oversight and surveillance of copper trading. Specifically, the Commission has worked with British regulators to bring to light trading irregularities on the London Metal Exchange. The CFTC has used its legal authority aggressively to uncover these activities. This situation remains a top Commission priority as we work with our British and Japanese counterparts to address methods and vehicles for assistance in pursuing the investigation.
In addition to issues relating to Sumitomo's trading specifically, a number of broad policy implications are raised by the developments in the copper markets which must be analyzed and addressed. Briefly, these include whether international cooperative agreements and arrangements are sufficient, whether minimum regulatory standards are appropriate, and whether domestic markets are adequately protected in instances where foreign regulatory schemes differ from our regulatory framework, but the foreign markets nevertheless have a direct U.S. presence.
The Commission believes that these complex issues should be discussed and analyzed as part of a broader international effort. Although the Commission believes that it is premature to make recommendations on these issues, the Commission has undertaken an across-the-board review of these and related issues. We will report back to our Congressional oversight committees on our findings.
We appreciate the opportunity to testify here today on this important subject. Hopefully, important lessons can be learned from the unfortunate situation created by HTA contracts in the Midwest. As always, the Commission will work with the Department of Agriculture and others to educate producers on the principles and techniques of prudent risk reduction. The Commission fully supports the development of new means of risk management, so long as they are legal, safe and fully understood by those using them.