Accountants, Farmers and Futures: Current CFTC
Issues
Joseph B. Dial, Commissioner
Commodity Futures Trading
Commission(1)
Annual Agribusiness Conference
Illinois CPA Society and
Foundation
Springfield, Illinois
September 5, 1997
Introduction
I would like to thank the Illinois CPA Foundation for inviting me to
address this distinguished gathering -- and for giving me the
opportunity to visit some part of Illinois other than Chicago.
Don't get me wrong, I have nothing against Chicago. It's a
wonderful city. But as a former agricultural producer, I have to say,
it's nice to visit a part of Illinois where one can see something
sprouting from the ground besides parking meters.
I have been asked to cover three subjects: (1) the CFTC's position
on the Financial Accounting Standards Board (FASB) proposal to change
the accounting treatment of hedge transactions; (2) the
Commission's ongoing rulemaking proceeding to consider lifting the
ban on agricultural trade options; and (3) internal controls as they
relate to agribusiness firms and farmers. Because there is very little
overlap among these topics, I believe the most useful way to proceed
will be to give my remarks as three separate and distinct
presentations, each followed by a Q&A period.
The Proposed FASB Rules
Turning first to the proposed FASB hedge accounting rules, I would
like to preface my remarks with a disclaimer. While the CFTC employs a
number of highly skilled accountants, I am not an accountant myself.
In fact, when I must deal with our accounting staff on technical
issues, I usually ask them to bring along a lawyer or an economist to
serve as a translator. Therefore, my remarks will be rather general in
nature and will not go into a great deal of detail about the technical
fine points of the FASB proposal. I will try to cover four areas: (1)
the basis for the CFTC's interest in hedge accounting issues; (2)
the history and rationale behind the FASB proposal; (3) the
significant issues in that proposal from the CFTC's viewpoint; and
(4) the current status of the FASB proposal. At the conclusion of the
presentation, I will entertain questions. If anyone comes up with a
technical question that stumps me -- possibly the easiest challenge
you will face during this entire conference -- I would ask that you
put it in writing and I will pass it along to our accounting staff for
you.
Basis for the CFTC's Interest in Hedge Accounting
Issues
The CFTC is an independent federal regulatory agency charged with
overseeing an important segment of the derivatives market --
exchange-traded commodity futures and options. Those exchange-traded
derivatives perform two vital functions for our nation's economy
-- hedging and price basing. To assure the proper performance of those
key economic functions, the CFTC administers comprehensive rules
intended to preserve market integrity, financial integrity and
customer protection. The CFTC is interested in the FASB accounting
rules only insofar as those rules might impose any unfair burden on
the industry we regulate or interfere with that industry's ability
to perform its vital hedging and price basing functions.
For example, all futures brokers -- known as futures commission
merchants, or FCMs, in CFTC parlance -- are registered with the CFTC
and are subject to agency-imposed minimum net capital rules. The CFTC
would not want the FASB's accounting rules to create arbitrary or
unreasonable blips in assets or liabilities that would throw those net
capital calculations out of whack. Even more important, we would not
want users of the futures market to make important trading decisions
-- decisions that could have a significant market impact -- based on
some quirk of the accounting rules rather than their legitimate
economic needs.
Finally, we would not want the FASB rules to put exchange-traded
futures markets at a competitive disadvantage to over-the-counter
(OTC) derivatives. In as much as futures markets do perform vital
economic functions, we don't want to see those functions
diminished. Nor do we want to see futures volume bled away to
unregulated, non-transparent markets, merely because of some arbitrary
glitch in the way the accounting rules are drafted or applied.
History and Rationale of the FASB Proposal
The history of the FASB proposal is laid out succinctly in an article
by Henry Davis in the July 1997 issue of Risk Magazine. It all started
with the "Financial Instruments Project," begun in 1986.
Within the context of that project, recognizing that existing guidance
was inconsistent and incomplete, FASB began deliberating in 1992 on
new, comprehensive standards for derivatives and hedge accounting. In
1995, the Board even considered doing away with hedge accounting
altogether. This approach would have measured all derivatives at fair
value on the balance sheet and classified them as either held for
trading or held for risk management. Derivatives held for trading
would have been marked-to-market constantly. Derivatives held for risk
management would have had their gains and losses carried in a separate
account and not recognized until the corresponding earnings were
realized.
The basic document at issue in the hedge accounting debate before us
today is a June 1996 FASB "Exposure Draft" entitled,
"Accounting for Derivative and Similar Financial Instruments and
for Hedging Activities." This draft would preserve the idea of
measuring derivatives at fair value and recognizing them on the
balance sheet, but return to the concept of hedge accounting for
hedging instruments, hedged assets and liabilities, firm commitments
and certain forecast transactions. As described in the Davis article,
the exposure would allow hedge accounting for three types of
transactions:
a fair value hedge -- a hedge of the exposure of a recognized asset or
liability to changes in fair value;
a cashflow hedge -- a hedge of the exposure of a forecast transaction
to variable cashflows; and
the hedge of a foreign currency exposure of a net investment in a
foreign operation.
In July of 1997, after reviewing more than 240 comment letters on the
June 1996 Exposure Draft, FASB issued a summary of what it described
as "tentative decisions" made during the Board's
"partial redeliberations" of the issues in the Exposure
Draft. That brings the history of the FASB proposal up to date. What
happens next in the process I will describe later in the context of
the proposal's current status.
Turning now to the rationale behind the Exposure Draft, concern had
grown within FASB, and the accounting profession in general, that
balance sheets have not accurately portrayed derivatives exposure.
Currently, most derivatives don't show up on balance sheets
because they don't have a "historical cost" -- defined
as the amount a dealer would be willing to pay to buy or sell a
derivatives contract on the day it is entered into. As the volume of
derivatives transactions -- both exchange-traded and OTC -- has grown,
stockholders have sometimes been blindsided by derivatives losses that
were not adequately exposed on company balance sheets. One
well-publicized example of such a loss was the subject of a 1994 CFTC
enforcement action. In December 1994, BT Securities agreed to payment
of a $10 million civil penalty, along with other relief, to settle
companion enforcement actions by the CFTC and the SEC relating to
material misstatements by BT Securities to its derivatives customer,
Gibson Greetings. By misleading Gibson about the magnitude of its
derivatives losses, BT "caused Gibson to make material
understatements of the company's unrealized losses from
derivatives transactions in its 1992 and 1993 notes to financial
statements."
To prevent the publication of misleading financial information and
provide accurate disclosure of derivatives exposures, the FASB rules
are intended to bring derivatives onto corporate balance sheets so
that investors and others can appreciate their potential impact. The
affected companies say they don't object in principle to
disclosing their derivatives exposure, but the devil is in the details
and there has been a great deal of controversy concerning the proper
way of accounting for that exposure. In particular, where the
derivatives are part of a hedge, there has been a concern that the
accounting treatment should accurately reflect the total hedging
strategy, without causing financial statements to reflect earnings
volatility that isn't really there.
Significant Issues from the CFTC's Viewpoint
The primary concern expressed in the Commission's comment letter
on the June 1996 Exposure Draft related to parity of treatment between
exchange-traded and OTC derivatives. The letter states that, "the
Commission believes that it is important that the same
accounting treatment -- that is, deferral of gains and losses or
immediate income recognition -- should be accorded an economic hedge
transaction, regardless of the type of derivative product chosen as
the hedging instrument." The CFTC's particular problem
related to roll-over hedges -- a situation where a firm seeking to use
futures to hedge a longer term cash market risk might find that a
futures instrument with a maturity long enough to match the cash
exposure is not being traded or is prohibitively expensive. Thus, the
hedger would need to establish a futures position with a maturity
shorter than the cash exposure and subsequently roll the futures hedge
forward into a later futures month. Under the Exposure Draft, gain or
loss on the futures hedge would have been recognized when it was
rolled-over. On the other hand, with an OTC hedge performing an
identical function, but structured with a maturity matching the hedged
item, the gain or loss would not be recognized until the hedge
matured. The Commission argued that this disparate treatment would
bias hedgers against using exchange-traded futures in favor of OTC
derivatives.
The proposed revisions announced in July 1997 would address this
concern by allowing roll-over strategies as long as the hedge matches
the underlying risk. More specifically, roll-over strategies may be
used to hedge forecast cashflow variability as long as the cashflows
of the derivatives used are expected to offset substantially all of
the cashflow variability attributable to the risk being hedged.
Other key changes relate to fair value, and cashflow, hedge
accounting. With respect to fair value hedge accounting, the Exposure
Draft had proposed recognizing in earnings the gain or loss on the
hedging instrument along with the entire gain or loss on the
hedged item. However, the July 1997 revisions would recognize in
earnings only the gain or loss on the hedged item
attributable to the risk being hedged. In other words, the hedge
accounting rules would no longer require firms to recognize in
earnings the fair value of the hedged item not related to the
hedge.
With respect to cashflow hedge accounting, the Exposure Draft required
that, if a firm discontinued cashflow hedge accounting, the net gain
or loss accumulated up to that date would be recognized in earnings on
the original projected date of the forecasted transaction. The
proposed revisions would allow firms to recognize the gain or loss
immediately, since it is probable that the original forecasted
transaction will not occur.
Commission staff members are studying other aspects of the FASB
proposal and still have three remaining areas of concern. First,
complexity -- the proposal requires firms to undertake some rather
complex calculations, especially the requirement that they compute the
effectiveness of each hedge. Second, confidentiality -- the
disclosures required for each hedge are so detailed that they can
reveal sensitive and confidential information. Finally,
understandability -- firms may have problems understanding and
applying the complicated hedge accounting requirements, especially
given the relatively short amount of time before implementation.
Current Status of the FASB Proposal
On July 24, 1997, the FASB published a 27 page summary of the
"tentative decisions" made to that point during its
"partial redeliberations" on the issues aired in the
Exposure Draft. The document listed 22 "key changes from the
Exposure Draft." The Board is expected to follow up this
preliminary document with a final draft or "working model"
of the new standards, which would be submitted for comment to the
Financial Instruments Task Force, a FASB advisory group, and also made
available to the public. Interested parties would be given 45 days to
comment. After reviewing the comments, the Board would issue final
standards on accounting for derivatives hedging before the end of
1997. The new standards would be effective for all fiscal years
beginning after December 15, 1998.
There has been a rather loud chorus of complaints concerning both the
specifics of the proposal and the process of going straight to a final
standard when there are such extensive changes. The 14,000 member
Financial Executives Institute and the 10,000 member Treasury
Management Association have both called upon FASB to issue a new
Exposure Draft, a step that would probably delay implementation of new
standards for at least another year. The Financial Accounting
Standards Advisory Council, another FASB advisory group, was split
almost evenly on the issue. Some members favored issuing a new
exposure draft because of the extensive changes from the earlier
document. Others opposed such action on the grounds that those changes
were, in fact, responsive to the comments on the June '96
document, ample due process had been given, and issuing a new draft
would cause too much of a delay in implementing the new
standards.
On July 31, senior executives from 22 major corporations, including
the ten largest US banks, and other entities, from Fannie Mae to
Goldman Sachs to Hershey Foods, wrote to FASB and the SEC, which
enforces FASB standards. The executives expressed concern about FASB
going forward with a final standard, without exposing it for pubic
comment and debate, especially in view of "the evident complexity
of the new approach, the speed with which it has been developed and
the significant changes to the exposure draft since it was released
more than a year ago." They argued that FASB may not have
adequately considered a wide range of concerns, including "the
potential impact on the capital markets, the weakening of
companies' ability to manage risk, and the adverse control
implications of implementing costly and complex new rules imposed at
the same time as other major initiatives, including the year 2000
issues and a single European currency."
On that same day, Fed Chairman, Alan Greenspan, wrote an equally
strong letter to the Chairman of FASB warning that "The proposal
may discourage prudent risk management activities and in some cases
could present misleading financial information." He argued that
the proposal could "inappropriately increase the reported
volatility of earnings," "reduce the reliability of
financial statement values," and "potentially permit
abuses" arising from over- or understatements of values. In view
of all these concerns, Greenspan too favored republishing the
proposal, and even went so far as to suggest an alternative approach
whereby the fair value of hedges would be reported in a supplement to
the financial statement rather than replacing the current system
altogether.
There is also a possibility that Congress may weigh in on this issue.
Senator Phil Gramm, Chairman of the Securities Subcommittee of the
Senate Banking Committee, has criticized the FASB proposal and members
of his staff have been quoted in the press as suggesting that hearings
before the Subcommittee are a possibility. While Congress has no
direct authority over FASB, the Banking Committee does exercise
jurisdiction over the SEC, which enforces FASB standards. It was
suggested in the press reports that such hearings might look into the
whole FASB rulemaking process.
For the moment, however, FASB, with the encouragement of the SEC,
appears to be hanging tough. In response to the July 31 letter from
banking and business executives, FASB Chairman, Edmund Jenkins,
stated:
Companies currently omit from their financial statements billions of
dollars in transactions in derivative instruments each year. That
makes it difficult for investors to properly evaluate those
companies' financial positions and risks. The requirements in the
Board's proposal would remedy that lack on information.
In response to Chairman Greenspan's letter, Mr. Jenkins stated,
"Your approach - when compared with ours - would reduce the
information available to investors and creditors."
The SEC's chief accountant, in a statement released on August 11,
supported the FASB position, arguing that "Further delays in the
process are unwarranted and put investors at risk." Likewise, SEC
Chairman, Arthur Levitt, in a speech in May, argued that the requests
for delay on the FASB proposal don't take into account ten years
of study and debate on the hedge accounting issue. "These
delaying tactics" he said, "are inconsistent with the way
the standard-setting process should be conducted." Thus, the
battle lines are clearly drawn.
I hope this has given you at least a general overview of the FASB
hedge accounting proposal and the CFTC's concerns about it.
Speaking as a non-accountant, I find the politics of the process
somewhat more interesting than the dry technical issues -- and there
certainly seems to be enough politics going on. Fortunately from the
CFTC's point of view, the agency's interests in the FASB
proposal are relatively discrete, so that in this particular political
battle, the CFTC can gladly claim status as a non-combatant.
At this point let me thank you for your kind attention and -- with no
small measure of trepidation -- open the floor for questions.
Agricultural Trade Options
The second area I would like to discuss with you today involves
agricultural trade options. These instruments, which represent a new
and potentially very useful risk management tool for America's
farmers, are currently the subject of an ongoing CFTC rulemaking
proceeding. I will cover the definition, history and current status of
agricultural trade options.
Definition of Agricultural Trade Options
A trade option is an off-exchange commodity option offered to a
commercial person or entity for purposes solely related to that
commercial's business. An option buyer has the right, but not
the obligation, to make or take delivery of the commodity. Trade
options have many potential benefits. The most obvious is that they
offer producers the ability to lock in downside price protection
without cutting off upside price potential. Thus, for example, a
farmer might buy a put option giving him or her the right to sell a
portion of their crop to the option grantor at the "strike
price." If the market price drops below the strike price, the
option is exercised and the producer can sell to the grantor at that
price, thereby covering the cost of production, or some other level of
price protection that he or she has selected. On the other hand, if
the market price goes up, the producer can forfeit the premium,
abandon the option, and sell the commodity in the open market.
The grantor, or writer, of such an option might be the local elevator,
which also could benefit from trade options in one of several ways.
For example, unlike exchange-traded options, these off-exchange
instruments can be customized to meet the specific needs of each
producer's operations, giving elevators more flexibility in
offering risk management opportunities to farmers. They also could
provide a chance to generate additional income for the elevator
through option premiums. Finally, a trade option is more likely to be
accepted by the farmer for the very reason that it is being offered by
the local elevator -- a firm he knows and trusts.
On the other hand, the producer gains these benefits at the cost of
certain inherent advantages of the exchange environment, such as the
clearinghouse guarantee. However, the futures exchanges will still be
involved indirectly in the trade option process. Responsible elevators
can be expected to cover the net price risk they undertake in writing
trade options by themselves entering into exchange-traded options,
thereby creating additional volume for the exchange marketplace. Thus,
the producers, the elevators and the exchanges all stand to benefit
from agricultural trade options.
History of Agricultural Trade Options
That's the good news about agricultural trade options. However,
there's one rather significant piece of bad news. Despite their
potential benefits, agricultural trade options are currently subject
to a regulatory ban. The history of that ban is long and convoluted,
but let me give you a condensed version, just to put the current
status of this issue in historical perspective.
In 1936, Congress prohibited options trading -- both on- and
off-exchange -- in all commodities then regulated under the Commodity
Exchange Act. The prohibition was a response to a history of
manipulation and price disruption in the futures markets attributed to
options trading. The prohibition applied to all the
"enumerated" agricultural commodities named in the 1936 Act.
In subsequent years, as new contracts came on line -- for example,
livestock and the soybean complex -- the statutory list of enumerated
commodities grew, and so did the reach of the options ban.
In 1974, when Congress created the CFTC, it gave the agency
jurisdiction over futures and option trading in all commodities
-- including authority to ban or allow options in the
new, non-agricultural commodities coming under regulation for the
first time. However, Congress left in place the statutory ban on
options in the enumerated agricultural commodities.
In 1978, in response to widespread retail fraud, the Commission banned
off-exchange retail options in non-agricultural commodities. The ban
did not, however, extend to trade options involving commercial
parties. Commercials in the metals and energy fields had been using
trade options for years with no problems or abuses and we saw no need
to interfere with their legitimate business practices.
In 1981, the focus switched to exchange-traded options. The Commission
okayed a pilot program for exchange-traded options in the
non-agricultural commodities. The non-agricultural pilot program was
such a success that in 1982 Congress lifted the statutory ban on
agricultural options and gave the Commission the authority to allow
agricultural options. We exercised that authority by adding
agricultural options to the exchange-traded pilot program in 1984. The
pilot program was ultimately made permanent and exchange-traded
options have become a huge success for both agricultural and
non-agricultural commodities.
Nevertheless, because of the history of problems and abuses in
off-exchange options, the Commission decided to leave the ban on
off-exchange agricultural trade options in place for the time being.
In 1991, after several years of experience with exchange-traded
options, the Commission proposed a rule lifting the ag trade options
ban. The comments we received revealed a lack of consensus within the
agricultural community on lifting the ban and the 1991 proposal was
never enacted. However, agricultural trade options remained a
"live" issue and were discussed at several meetings of the
CFTC Agricultural Advisory Committee.
Current Status of Agricultural Trade Options
By 1994, I had become convinced that the Commission needed to take
another look at giving people in agriculture the same opportunities as
those in the metals, energy and financial fields -- the chance to add
trade options to their arsenal of risk management tools. My view was
based on several developments, including: (1) the success of
off-exchange trade options in non-agricultural commodities; (2)
the success of exchange-traded options in both agricultural and
non-agricultural commodities; and (3) farmers' need for the widest
possible variety of risk management tools in today's highly
competitive agricultural markets.
In December 1995, the Commission began a reconsideration of this
important issue by hosting a public roundtable discussion of
agricultural trade options. The 17 participants represented a broad
cross section of agriculture, as well as academia and the futures
industry. While some still expressed reservations, there was general
support for relaxing the ag trade options ban, based on an increased
need in modern agriculture for a variety of risk shifting tools. The
Commission directed its staff to study the issue and report on its
findings.
The staff study culminated in a "white paper," published in
May of this year, entitled "Policy Alternatives Relating to
Agricultural Trade Options and Other Agricultural Risk-Shifting
Contracts." The white paper recommends that the Commission
consider lifting the agricultural trade option ban, subject to
appropriate conditions. The initial steps in that process are well
underway. The June 9, 1997 Federal Register included an
Advanced Notice of Proposed Rulemaking requesting comment on whether
the Commission should propose rules to lift the ban and, if so, the
appropriate conditions for doing so. The Notice included a list of
some 30 questions and was subject to a 45-day comment period.
Also, the Commission held two public meetings to collect first-hand
testimony from interested parties concerning the issues raised in the
Federal Register Notice. The first of these meetings was held
in Bloomington, Illinois, on July 10th, and the second in Memphis,
Tennessee, on July 16th. These meetings enabled all five CFTC
Commissioners to hear directly the views of a wide range of producers,
processors, and other agribusiness interests.
In addition, on July 31, the National Cattlemen's Beef Association
hosted an open forum at its Summer Conference in Reno, at which I and
a staff member from the Commission's Division of Economic Analysis
discussed the staff white paper and answered questions about
agricultural trade options and the Federal Register Notice. The
session gave cattlemen an opportunity to learn more about the
Commission release and to express their views on agricultural trade
options. Transcripts of all three of these public meetings were
submitted for inclusion in the public comment file on the Advance
Notice of Proposed Rulemaking.
Based upon an analysis of all the relevant information, including a
review of the nearly 100 comments received and the recommendations of
the agency's staff, the Commissioners will determine the
appropriate action to take regarding agricultural trade options.
As the Commission and the agricultural community move through the
deliberative process regarding agricultural trade options, I believe
we need to view this issue not only in the context of today's
environment, but also in light of the different business models that
may be used in the future. To illustrate my point, let me tell you a
quick story about one of the National Hockey League's all-time
super star players. When a reporter asked Wayne Gretsky why he was so
good, he replied, "other hockey players skate to where the puck
is, I skate to where the puck is going to be."
Internal Controls as They Relate to Agribusiness Firms and
Farmers
In this final segment of my three part presentation I will talk about
the internal systems and controls agribusiness companies should have
in place. I respectfully suggest that CPAs, working hand in hand with
a company's board of directors, are the two key players in making
sure internal systems and controls are implemented and work
properly.
This topic is an appropriate follow-up to the prior segment concerning
lifting the ban on agricultural trade options. The concerns posed by
many of the shareholders in American Agriculture about agricultural
trade options relate to the potential for abusive trading practices or
elevator defaults involving those instruments. The best defense
against abuses and defaults is effective internal controls. Do CPAs
need to direct their attention to this area? To answer that question,
I would refer you to the testimony of Mr. Clifton Duckworth at the
December, 1995, CFTC Roundtable on agricultural trade options, Mr.
Duckworth is a principal with the Illinois Ag Auditing Association
located in Bloomington.
In his statement at the December Roundtable, held in Washington, DC.
Mr. Duckworth noted that his group audits about 150 cooperatives each
year, mostly in the grain area. Among other things, he expressed a
serious concern, based on his experience with those audits, that there
was a real need for elevators to improve their record keeping.
Apparently, the National Grain and Feed Association shares that
concern because in 1996 they published a "white paper"
entitled "Hybrid Cash Grain Contracts, Assessing, Managing and
Controlling Risk."
You may be familiar with the NGFA publication, so I will apologize up
front to those of you who may have already read it because I am going
to refer to it several times in this segment of my presentation. The
white paper was prompted by problems encountered by farmers and
elevators involving "hedge-to-arrive" and other hybrid cash
grain contracts. However, the guidance it provides is broadly
applicable to business practices in general. I personally think it is
an excellent roadmap for elevators, bankers and accountants to follow
as they deal with the reliability of an agribusiness company's
financial record keeping system. Furthermore, it has been widely
distributed for use by the grain industry and I see no reason for me
to reinvent the wheel as I talk about internal controls.
To give you an idea of the range of critical issues covered in the
NGFA white paper I will list them as they appear on page 28 of that
publication.
CRITICAL ISSUES
Market Risk
I. Understanding, quantifying and managing price
risk.
Counterparty Credit Risk
II. Why it exists and how to avoid losses.
Internal Systems and Controls
III. Systems needed to manage new contracts
Lending Issues
IV. How to manage the impact of hybrid cash contracts on credit
lines
Customer Relations
V. Understanding the impact of hybrid cash contracts on
customers
Legal and Regulatory Issues
Critical legal issues and status of federal and state
regulations
Tax and Accounting Considerations
Unique issues relating to hybrid cash contracts
In pointing out these critical issues, the authors of the white paper
state, "Effective risk management requires policies, practices,
procedures and support systems that address each of the risks in the
matrix." The "matrix" shows the level of relative risk
both the buyer and the seller incur on each one of 12 different
contracts. If you haven't already done so, I urge you to read the
NGFA publication. I think it is a worthwhile guide you could use as
part and parcel of the services you perform. To reinforce my point,
let me give you some examples of what the white paper has to say on
the subject of internal systems and controls.
INTERNAL SYSTEMS and CONTROLS
In addition to market risk and counterparty credit risk, companies
offering hybrid cash contracts also face administrative risk, defined
here as the risk of loss occurring as a result of inadequate systems
and controls, human error or management failure.
Companies should not engage in more complicated marketing
strategies if their systems or internal controls are not sufficient to
adequately confirm contracts, execute contracts, and provide enough
information to monitor contract exposure and manage related risks. The
degree of sophistication of systems and controls should be
commensurate with the complexity of the contracts and the level of
risk.
Fundamentals of effective internal controls are:
Oversight by senior management and/or board of directors;
Written policies, practices and procedures;
Separation of contracting and control responsibilities;
Integration and reconciliation of reports to the books;
Skilled and experienced personnel;
Timely reporting of financial position, exposure and risk; and
Technology commensurate with the level of risk.
Although you are familiar with the common controls for traditional
cash contracts, I think it is important to quickly review NGFA's
list before moving on to their coverage of options-based
contracts.
Common controls for traditional cash contracts
are:
I. Daily reconciliation of manual- and computer-generated position
reports;
II. Daily review of new contracts for reasonableness;
III. Daily reconciliation of broker statements to position
reports;
IV. Daily review of contract changes or deleted
contracts;
V. Receipt of written trade confirmation from the
counterparty;
VI. Periodic valuation of market positions (frequency depends on
the size and risk profile of the positions).
Options-based contracts present these additional critical
systems and control issues:
I. Identifying the option commitment(s) embedded in a cash
contract to insure proper position reporting and hedging.
II. Periodic valuation of cash contract for financial reporting
(requires valuation of embedded options).
III. Matching option commitments in cash contracts with hedges in
the futures market to establish options risk.
IV. Contract amendments for expiring options.
V. Proper classification of funds received for option transactions
from both the customer and the broker.
Additional comments in the "white paper" on options-based
contracts are as follows:
One of the biggest concerns with options-based contracts is the
possibility that options commitments embedded in the contract are not
integrated into position reports. This could result in either a lack
of hedging or improper hedging of the options risk. Effectively
identifying options exposure and including the options commitment in a
position report, as illustrated in the Market Risk section of this
white paper, would significantly reduce this concern.
Systems and controls for options-based contracts depend upon the
type of contract being considered. Special attention should be given
to pricing mechanics. Identifying precisely when an obligation exists
and at what point price risk is transferred are important factors in
managing options risk.
This is good advice on how options-based contracts should be treated in the context of the exchange-traded options available today. It will become even more critical that these recommendations be adhered to rigorously if the Commission lifts the ban on agricultural trade options and we see a significant increase in the variety of option-related products and parties using them. The NGFA publication has an excellent section on internal controls for hybrid contracts. I don't have time to cover it today. Nonetheless, I commend it for your consideration.
Before I leave the white paper let me cover one more important point
that the authors make. It has to do with the valuation process and I
think you will agree with their statements, which are as
follows:
Valuation Process
The valuation process is critical to risk identification and the
integrity of profit and loss reporting. Valuations should be done by
accounting/administrative personnel, not by trading personnel. For
risk-management purposes, contract valuation should occur at least
monthly, and more often, depending upon market volatility, potential
dollar loss, position size and the capital position of the
firm.
The valuation procedures should be part of a company's practices and procedures manual. They should cover all aspects of the valuation process, such as:
sources of input;
frequency;
responsibilities; and
methods for valuing more complex or illiquid cash contracts.
Conclusion
In closing, let me leave you with two thoughts. First, there is a
perception on the part of many people, a few CPAs included, that
derivative instruments -- both exchange-traded futures and options and
over-the-counter instruments, are perilous to one's financial
well-being. In response to that fear, I think it is important to
repeat a point of view recently expressed by Jerry L. Jordan,
president of the Federal Reserve Bank of Cleveland.
"Derivatives," he said, "don't add to the risks
inherent in a modern financial system. They do, however, allow risk to
be borne more efficiently."
Second, notwithstanding the media's delight at blaming derivatives
for most of the financial train wrecks that have happened in the last
decade, the truth of the matter is that the contracts themselves are
not the culprit. The real reasons individuals or companies lost money
in those situations stems from occasional fraud or, more frequently,
the failure to have an adequate system in place to control and
identify the exact amount of money they had at risk and do so on a
timely basis.
In the new era for agriculture farmers and elevators will have to do a better job of managing their business risks. That's where you come in, because your services can make the difference between proper internal controls that enhance an individual's or company's financial integrity or deficient internal controls that become the weakest link in the risk management process and may cause irreparable financial harm. I know you are up to the task!
1. *Please note: the views expressed herein are those of the author and do not necessarily reflect those of the Commodity Futures Trading Commission or its staff.