NATIONAL GRAIN TRADE COUNCIL
Transportation, Elevator & Grain Association
2005 Annual Meeting
“The Future of the Futures Industry”
Acting Chairman, U.S. Commodity Futures Trading Commission
February 3, 2005
Thank you for your kind introduction. I appreciate the opportunity to address the National Grain Trade Council today. The weather here is certainly a break from what we’ve had back in Washington over the past few weeks. Tomorrow I’ll be addressing the American Bar Association in Key West, Florida, so it will be at least a couple of days before I need to get back to the reality of winter.
As I said, it’s a pleasure to be here today, especially because I look forward to the opportunity to address groups involved in agriculture. Although financial commodities dominate the futures markets today, we all know that agriculture was the birthplace of the modern futures industry. Unfortunately, some would point out that agriculture has been left behind by the modern derivatives markets, and in my remarks today, I would like to focus on that issue.
Although my professional background is in economics and finance, I was born on a farm in the Shenandoah Valley of Virginia. As a farm kid from White Hall, Virginia, I was surrounded by cornfields, apple orchards, Herefords and Holsteins. The first vehicle I drove was a tractor, my best friends were fellow 4-H club members, and my first job was in the local farm market. This background was a gift of my late father, who continued to pursue farming, despite its lack of profitability at the time, and my mother, whose parents homesteaded in Saskatchewan, Canada.
Before I get too far along, I would like to note that the views I express today are my own and not necessarily that of the other Commissioners or the staff of the Commodity Futures Trading Commission.
When President Bush first asked me to serve as a Commissioner at the Commodity Futures Trading Commission in 2001, I had to ask myself, what could I bring to the Commission? I did have somewhat of an advantage in that I had previously worked as a research economist at the Commission between 1990 and 1995. I also have had the opportunity to do quite a bit of research on the futures and options markets, both while I worked at the Commission and afterwards as a finance professor at Tulane University and then at George Mason University. I’ve taught students, entrepreneurs, and businesses how to use futures and options contracts. So I knew a lot about the markets and how to use them.
But as a Commissioner and now as Acting Chairman of the CFTC, I am being asked to do something very different. I am asked to regulate the markets, and I must resolve with myself what that means and what I can personally contribute to the regulation of the futures and derivatives markets.
So what is the answer to the question? Being an economist, my first instinct is to let the markets work. One of the lessons that the U.S. economy demonstrates to the world on a daily basis is that competitive markets generally work very well. And, they tend to do this all on their own. As economic agents, we Americans are generally very good at collecting and processing information to arrive at prices to exchange goods. And we are extremely good at devising ways to exchange goods and facilitate commerce. E-Bay, for instance, is really an extraordinary example of how to elevate the humdrum garage or yard sale into a high-tech solution to cleaning out one’s attic or basement!
For me, then, I see an important role as a regulator as a promoter of markets and market solutions. That said though, markets do not always work as we would like. For example, we know that where monopolies or oligopolies exist, markets tend not to price and allocate resources optimally. Likewise where economic agents are not well informed, counterparties can take advantage of them. An example of this that I see all too often is in retail forex markets. Hardly a week goes by at the Commission that I don’t see a case recommended by our Division of Enforcement to shut down some high-pressure boiler room pitching investments in foreign exchange contracts. Typically these operations are pitching what they say are high return, low risk—or no risk—investments to consumers who don’t realize that such promises are pie in the sky. Thus, I see an equally important role for the regulator as protector of the markets and market users.
When it comes to promoting market solutions, I can rely on folks like you who are in the markets everyday. Each and every one of you is out there constantly looking for better solutions to everyday situations. You are always asking yourself are there contracting alternatives that I can use in my business that will aid my business? And when one of you comes up with a better alternative, you know that your competitor, who may be sitting next to you here today, is busy dreaming up his or her own innovation.
The rub occurs when the promotion of market solutions comes up against the regulator’s role of protecting markets. There is often a temptation to overprotect markets and market participants, usually through extensive licensing, registration, and reporting requirements, and even by government approval over what can be offered to whom and how. The problem is that an overly restrictive regulatory environment that uses these prescriptive approaches can sometimes slow down the development and availability of innovative products to manage risks as well as innovative means to acquire those products. When innovation is stifled, everyone—whether you are an elevator operator, a producer, a miller, a crusher, or anyone in the production and consumption chain of a commodity—suffers because of the missed opportunity to lower costs or effectively manage risks through the use of innovative products.
The Commodity Futures Trading Commission, created in 1974 and given exclusive jurisdiction over futures markets, has had the unique challenge of regulating derivatives, perhaps the most innovative markets of our time. In our case, coping with market innovation was complicated by the fact that many new products were hybrids, sometimes combining features of derivatives, securities, and physicals, and often offered over-the-counter. As such, it was sometimes unclear which regulatory authority had jurisdiction.
During the 1990s the Commission struggled in its effort to bring legal clarity to the derivatives markets, embarking on numerous studies, interpretations, concept releases, no actions, and exemptions. Recognizing that this situation was threatening the derivatives markets and the ability of those markets and their participants to compete in the global economy, Congress stepped in. Assisted by many forward looking leaders in our industry, they hammered out the Commodity Futures Modernization Act. The CFMA, passed in 2000 as part of our reauthorization by Congress, provided a blueprint for regulation in a market characterized by rapid growth and change.
The thrust of the CFMA was, first, to provide legal certainty for innovative products in the OTC markets via specific exclusions and exemptions that would enable new entrants and new products to be traded without the deliberate imprimatur of the Commission. Second, the CFMA enabled the Commission to move from a prescriptive regulatory model to a principles-based model that set out fundamental principles for product offering and market operation while ensuring that the CFTC’s mandates for customer protection, financial soundness, and economic integrity are fulfilled.
The CFMA also recognized that not all markets and not all participants are created equal. During the late 1980’s and throughout the 1990’s there was significant movement, particularly among commercial participants in the financial and energy markets, to develop over-the-counter derivatives such as swaps and forward rate agreements. Congress recognized that such markets did not require the level of supervision traditionally applied to the exchange-traded markets due to the sophistication or commercial expertise of the participants in these markets.
The CFMA also gave traditional futures exchanges greater autonomy in operating and regulating their business. To this end, Congress choose to regulate the futures and options industry through core principles, where general regulatory guidelines and goals are set forth to govern market activity—but the industry itself determines exactly how to meet those goals. Gone then were the paternalistic and prescriptive regulations of the past. So too was the requirement that exchanges have their contracts approved prior to being able to list them for trading. Instead, exchanges are given the ability to certify that proposed contracts meet the Act’s core principles and begin trading them immediately.
Under the CFMA, the Commission has worked diligently to reduce burdens on market participants, encouraging market innovation while at the same time protecting market participants and customers. I believe that as a result of these efforts, we have seen a healthy growth in exchange-traded and OTC financial derivatives markets, while at the same time there has not been any increase in problems associated with these markets. From the year 2000, when the CFMA was passed, through 2004, the volume of trading on U.S. futures and options market has risen from about 600 million contracts to in excess of 1.2 billion contracts. In the swaps markets, notional values outstanding have risen from 63 trillion dollars in 2000 to more than 164 trillion dollars by mid-2004. What this illustrates, and I don’t have to tell this audience this, is that where innovation is enabled, markets flourish. Even trading in agricultural commodities, though now small relative to the financial and other physical commodities, saw volumes rise from 2000 through last year.
Certainly many of the advances of the regulatory approach of the CFMA play a role in the agricultural derivative markets, but there is no denying that many of the most significant changes have been limited to non-agricultural commodities. For example, Section 2(h)(3) of the Act establishes an exemption for certain transactions entered into on a principal-to-principal basis between commercial entities and traded on an electronic trading facility. One electronic exchange that some of you may have heard of, which operates under this exemption, is the Intercontinental Exchange located in Atlanta, Georgia. This exchange is open to commercial market participants and lists hundreds of contracts in precious metals, petroleum, natural gas, and the electricity complex. Note that agricultural commodities are not listed. This is because the exemption only applies to so-called “exempt” commodities, which does not include agricultural commodities.
Another example is the exclusion for swap transactions under Section 2(g) of the Act. Some of you may recall that back in 1993, the Commission adopted an exemption for swap agreements under Part 35, allowing certain, mainly commercial entities, to enter into swap agreements with each other. While the market for agricultural swaps is small compared to that for interest rate or foreign exchange swaps, it nonetheless offers an innovative derivative-contracting alternative for companies in a position to use them. Notably, then, while Congress recognized the desire to exclude all non-agricultural related swaps from the Commission’s jurisdiction, it retained jurisdiction for agricultural products. As a result, the Commission has exercised its Part 35 Swaps Exemption which, while quite broad, has at times been interpreted by the Commission as not applying to certain agriculture transactions entered into by less financially well-to-do counterparties.
So where do we stand today with respect to the modernizing regulations applicable to the development of innovative contracting in the agricultural markets? Sadly, while we have made some progress, I believe much more can be done to promote innovation in the agricultural markets. Let me be clear, while exclusions or exemptions to the Commodity Exchange Act are the business of Congress, I believe that the Commission can also take action to bring clarity to contracting practices in agricultural markets so that innovators understand where the boundaries are between what are legal cash contracts and what crosses the line into the Commission’s jurisdiction. If such clarity is apparent, elevators, producers and commodity users can feel secure with the understanding that they are operating in a legal fashion and not have to operate in fear that the Commission is looking over their shoulder ready to pounce.
When we think about the positive role that government can play in our markets, we naturally focus upon developments occurring on Capital Hill and rule making by the Commission. We sometimes lose sight of the fact that the day-to-day activities that the Commission carries out in its enforcement and adjudicatory capacities also profoundly affect the environment for innovation. I would argue that the positive changes wrought by the passage of the CFMA can by stymied, in part, by paternalism in our adjudicatory actions. Indeed, at times, we seem to be working at cross-purposes: while Congress and the Commission in recent years have initiated a number of initiatives to reduce regulatory burdens on market participants and to encourage market innovation, the Commission in its adjudicatory and enforcement capacities has in certain cases acted to impede the introduction of innovative financial tools, especially in the agricultural sector.
Let me illustrate by discussing a few recent cases. As many in this audience are aware, the Commission, in November of 2003, issued three decisions involving the legality of innovative marketing tools in the agricultural sector. Two of these decisions—the Grain Land Cooperative and Competitive Strategies—matters focused on the legality of “hedge to arrive” contracts, in particular whether they were illegal off-exchange futures or simply forward contracts not subject to our regulatory jurisdiction. The third matter involved Cargill, Inc.’s Premium Offer Contract, and the issue there was whether it was an illegal call option or a forward contract. The Commission essentially came to a split decision in the two HTA cases, holding in the case of Grain Land that the contracts were forwards, but coming to the opposite conclusion in Competitive Strategies. In the Cargill matter, we summarily affirmed the administrative law judge’s ruling that the POC contracts were forwards.
Since I dissented in Competitive Strategies, the Commission--at least from my perspective--got it right in two of these three matters. If we were playing baseball in RFK Stadium, the new home of the Washington Nationals, this would be a fairly good record, since as they say in baseball, two out of three ain’t bad. But we are dealing here with commercial transactions in an important sector of our economy, where getting it wrong even on an occasional basis has serious ramifications. In my opinion, how we arrive at these outcomes can be as important as the outcomes themselves.
The major obstacle to progress in the agriculture sector, as I see it, lies with the Commission’s adherence to a legal approach for evaluating contracts that discourages innovation in this market. This approach, which has its origins in actions the Commission brought in 1979, in a case referred to as the Stovall case, and another in 1982 called Co-Petro, relies upon an unpredictable interpretation of whether the parties contemplated delivery in their dealings with each other. In other words, did the parties to the contracts regularly deliver against those contracts? The problem with this approach is that it uses as the defining characteristic a feature that is common to both forwards and futures—delivery. Further, it ignores the overriding logic of both the Commission’s Brent Crude Oil Interpretation and the Seventh Circuit’s landmark Nagel case—a case involving HTA contracts. The logic behind the interpretation and the court decision is that it is the contract’s economic function in the delivery process, not the regularity of the actual delivery itself that is the key to determining a contract’s nature.
The shortcoming of the Commission’s legal approach is that it looks “back to the future.” That is, it looks at what the parties did after they entered into their contractual relationship to determine what they agreed to in the first place. Now I recall that Back to the Future was an entertaining movie. But I don’t believe that even if we had a mad professor in residence at the Commission, like the one in that movie, peering into the past to divine the future, that it would suffice as an intellectually sound way to determine the parties’ intentions regarding delivery. The Commission’s approach, however, attempts to surmise whether the parties anticipated delivery at the time they entered into their HTA transactions by looking backward and selectively counting the deliveries that actually take place, rather than giving controlling significance to the written terms of the contract.
Now I suppose that if we owned a time machine like the one in the movie, we might be able to go back in time and find out what the parties were really thinking at contract inception, and use that as a basis for our decision--assuming, that is, that the fusion generator on our De Lorean was not malfunctioning. But alas, we are not so blessed, and neither, for that matter, is the Seventh Circuit. Nevertheless, that court has had no trouble ascertaining the legality of these transactions the old fashioned way. It does that--and I quote from the court’s opinion in Nagel--“just by reading the contract.”
Those that enter into these commercial relationships, in my view, need to know what they are getting themselves into. As Seventh Circuit Judge Frank Easterbrook reminds us, “[i]t is essential to know beforehand whether a contract is a futures or a forward.” You have to ask yourself, what sense does it make for a party to enter into a long-term business proposition, if it risks having the contractual arrangement that it entered into be deemed illegal years down the road? As we have seen, such uncertainty gave rise to post-contractual lawsuits and protracted Commission deliberation and review.
In my view, the uncertainty arises primarily from the multitude of factors that we consider in making our determination. At the Commission, we employ what is referred to as a “facts and circumstances” approach, which looks at an exhaustive catalog of features, conditions, and actions that are present during the transaction. The Commission maintains that its approach allows us to “look behind” any self-serving labels that the parties may give to their agreement and let us discern its “underlying purpose.” While such an approach gives the Commission a lot of discretion, it does little to clarify for the market what factors matter the most. In practice, a standard that eschews any clear line compromises the very ideals that drove Congress to pass the CFMA.
I believe that the Commission’s approach also fails to properly account for commercial reality. For example, in the Competitive Strategies decision, where a key innovation of the contracts offered by Great Plains enabled delivery to a third party elevator at the option of the farmer, the Commission insisted that the parties had to prove a connection between deliveries to third party elevators to the Great Plains’ contracts. This narrow interpretation of what constitutes delivery, combined with the parties’ failure to maintain adequate documentation, led the Commission to dismiss the deliveries as merely coincidental, and to declare the contracts illegal off-exchange futures contracts. The result is to legally discourage an innovative financial tool that allowed farmers to lock in a forward price while also enabling flexibility in delivery.
So in light of these shortcomings, how did we achieve better outcomes in Grain Land and Cargill? In the case of Grain Land, let me suggest it was largely due to the Commission’s belated recognition of the judicial consensus regarding the legality of contract rolling and cancellation clauses that commonly appear in HTAs. In the case of Cargill, it was due to the realization that Cargill’s contract was essentially a grain merchandising instrument that obligated both parties to deliver and accept grain, as the Administrative Law Judge so ably explained. I believe that we would be much better off if we abandoned our traditional approach of looking back to see whether delivery occurred and under what conditions, and instead followed the lead of the Seventh Circuit in the Nagel decision and relied primarily upon what the parties actually agreed to in their contracts.
Let me return now to another area where agricultural commodities have been treated differently than other commodities—trade options. As you know, the saga of trade options, which are off-exchange options involving commercial entities, is a long one. For those not familiar with it, let me attempt to give a short history. In creating the Commission in 1974, Congress gave jurisdiction over commodity options to the Commission, while at the same time banning them. Congress was aware, however, that these contracts could serve as a useful tool for commercial entities, so while they banned options generally, they did grant some relief to commercial options users by carving out an exemption for what were termed “trade options.” Again however, Congress chose not to permit trade options on certain agricultural commodities.
Over time, Congress eased the ban on options, giving the Commission the discretion to deal with them. In the early 1980’s the Commission allowed the exchanges to begin futures-style trading of agricultural options.
Notwithstanding the eventual success of exchange-traded agricultural options, the agricultural trade option ban stood in place until 1998 when the Commission lifted the ban, but with a significant number of restrictions and requirements. Despite some tinkering with the provisions in the regulations, as of today there is only one entity registered with the Commission as an agricultural trade option merchant and able to offer these options to producers. According to Commission records this merchant enters into a small number of options each year on lean hogs and live cattle.
Obviously, in its agricultural trade option regulations, the balance between promotion and protection of the markets has not been achieved. While the utility of these valuable risk-shifting instruments is clear, we have a regulatory program that is perceived by practically all elevator operators and other potential agricultural trade option merchants to be too burdensome to be worth the effort to offer the instruments.
In light of the advances in regulatory approach that have occurred under the CFMA, I believe that we need to better understand the perceptions of potential trade option merchants with respect to the burdens that may be placed on them if they choose to offer these options. We also need to better understand the effectiveness of the various regulatory requirements. For example, of what value are the reporting requirements imposed on these merchants if the Commission has no apparent inclination to review them or use them? Clearly, we must satisfy the concerns of farmers and producer groups and ensure that regulations effectively protect their interests without stifling the offering of this important risk management product to the agricultural market.
To sum up, I would note that there is no question that markets have changed: more global, more infused with technology, greater access, more diversity of products and techniques to manage everything from production to price risks. Yet, even as agriculture, and the grain trade specifically, have to contend with increased global competition, and with price volatility and the uncertainty that comes with it, some of the more useful innovations, risk management products, and technologies that have been developed and are widely in use in other industry sectors have not been offered and remain unavailable to the agricultural community.
If you read your history books, even the Bible, it is clear that risk management was invented in the agriculture industry. I am unapologetically certain that we who come from an agriculture background—who grew up rural; went to public schools—are capable of mastering the complexities of modern financial management and products, like options and swaps, that would be of value in this business. Since becoming a Commissioner at the CFTC, what has concerned me more than anything is the lack of availability of such products in the OTC markets that would work for the agriculture industry.
I strongly support the Commission’s taking another look at the agricultural trade option regulations to see whether a compromise can be reached that would balance producer concerns, the needs of the elevator industry, and the regulatory obligations of the Commission, so that agricultural trade options can truly come to the market. I also believe that innovative forward contracting, like that employed in Cargill’s POC contract and Competitive Strategies cross-country hedge-to-arrive contracts should be encouraged by the kind of legal certainty that we have afforded to the financial industry. In my view, our goals of promotion and protection can be accomplished by providing clear guidance on where we will draw the line between futures and physical transactions and by adopting a less prescriptive approach.
I believe firmly that education and disclosure can also make a significant contribution toward furthering our goals of promotion and protection. For example, I believe that the requirements and the risks associated with these kinds of contracts should be properly documented and accurately disclosed. I expect that when that does not occur, the Commission will initiate strong action, as we recently have in the forex area. By making clear in our rulemakings, in our enforcement actions, and in our adjudicatory decisions, the lines of our determination of what constitutes an illegal contract, we provide important guidance to the industry that will free it to innovate and provide the variety of contracts that will benefit farmers, merchants, and consumers.
Finally, I would like to comment briefly on the petitions received by the Commission to eliminate Federal spec limits. I have read the comment letter of the National Grain Trade Council, and generally support your comments. I think that the ag spec limits illustrate pretty well what I have been talking about today. As with the regulation of agricultural derivatives in general, these spec limits have been developed and applied in a haphazard sort of way. They apply only to certain agricultural commodities and are basically a historic artifact. In fact, federal spec limits were imposed in situations where the exchanges chose not to establish their own spec limit rules. So, for instance, there are spec limits on wheat because the Chicago Board of Trade did not have their own limits, but not on live cattle because the Chicago Mercantile did impose their own limits. Unfortunately, today speculative limits literally remain frozen in time, based on no compelling logic. However, what I have also found is that time is often slow to thaw. Nonetheless, I am committed to revisiting spec limits to at a minimum raise them to reflect current trading levels and also to work with the exchanges and agricultural industry to craft a long term solution.
I thank you for our attention today. In the coming months and years I also look forward to meeting with you to discuss issues and gain your input on topics of importance to the agricultural and futures industries.