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REVIEW OF POLICY ALTERNATIVES RELATING TO AGRICULTURAL TRADE OPTIONS

WEDNESDAY, JULY 23, 1997
House of Representatives,
Subcommittee on Risk Management
and Specialty Crops,
Committee on Agriculture,
Washington, DC.
    The subcommittee met, pursuant to call, at 1:30 p.m., in room 1300, Longworth House Office Building, Hon. Thomas W. Ewing (chairman of the subcommittee) presiding.
    Present: Representatives Pombo, Smith, Everett, Condit, Pomeroy, Baldacci, McIntyre, and Boswell.
    Staff present: Dave Ebersole, senior professional staff; Stacy Carey, director, Subcommittee on Risk Management and Specialty Crops; Ryan Weston, Callista Bisek, Wanda Worsham, clerk; John Riley, and Anne Simmons.
OPENING STATEMENT OF HON. THOMAS W. EWING, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF ILLINOIS
    Mr. EWING. The meeting of the Subcommittee on Risk Management and Specialty Crops to review the policy alternatives relating to agricultural trade option ban will come to order.
    I would like to thank each of the witnesses for participating in the subcommittee's review of policy alternatives concerning the ban on trading off-exchange agricultural options.
    Given recent CFTC action on this issue, the subcommittee believes it is important to receive comment from the Commission and the industry about the risks and benefits of lifting the ban agricultural trade options.
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    The U.S. Congress, through the passage of the 1996 Federal Agricultural Improvement and Reform Act, enacted sweeping changes to U.S. agricultural programs. The 60-year-old agricultural supply management programs were eliminated, enabling U.S. agricultural producers to better compete in the global market throughout the next century.
    For the first time in decades, U.S. agricultural producers will have full planting flexibility to rotate crops, which will result in a reduction of chemical and fertilizer use. This new flexibility for producers will ultimately place a larger emphasis on risk management for producers who will bear more responsibility for managing their price and yield risk on the farm.
    The new risk management focus emphasizes an important development in the agricultural sector, which traditionally looked to the government to manage its risk. Now more than ever, producers are looking to the market rather than to the government to manage risk.
    Producers will be looking for a wide variety of risk management options. Risk management for one producer may simply mean the purchase of crop insurance, while risk management for another producer implies use of the futures market.
    Today we will consider the risks and benefits of agricultural trade options as a viable risk management tool for producers.
    We in government have a responsibility to encourage innovation and competition, but we must also have a responsibility to assure the dissemination of proper information and proper regulatory oversight.
    The criteria for this review is similar to the same criteria involved in a recent review of legislative proposals to reform the Commodity Exchange Act.
    We must seek balance, the balance of allowing market innovation to develop and competition to proceed, while maintaining adequate enforcement and surveillance of the markets and protecting the public interest.
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    If any Member has a statement for the record, it may be included at this point.
    [The prepared statement of Mr. Condit follows:]
PREPARED STATEMENT OF HON. GARY A. CONDIT, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF CALIFORNIA
    Mr. Chairman, thank you for holding this oversight hearing regarding agricultural trade options. The Commodity Futures Trading Commission has asked industry for comments regarding whether the current ban on agricultural trade options should be lifted; and if so, under what conditions. The Commission's action is of great importance to our agricultural industry. In its report regarding agricultural trade options, the Commission's Division of Economic Analysis identified many opportunities that must be considered if agricultural trade options are to be permitted.
    The economic environment faced by farmers is one of great uncertainty. Uncertainty has increased in part because the 1996 farm bill ended the relationship between Government support payments and market prices for major crops. Consideration of the regulation of agricultural trade options by the CFTC is particularly appropriate at this time. Our Government farm and market regulation policies are clearly related and where possible should be complementary. An important goal of he farm bill is for our Government to help farmers identify tools which they can use to manage the risks they face. Agricultural trade options may prove to be appropriate for use by farmers if they are offered fairly and used prudently.
    Clearly any decision to lift he ban will carry risks. The Commission must carefully weigh the possible consequences of these risks which may be realized by industry if trading in these options is permitted. I look forward to continuing consultations with the industry and the Commission as the agency proceeds with its rulemaking process in regard to this important matter.
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    Mr. EWING. Again I would like to thank today's witnesses, and we look forward to hearing your testimony. I would ask the first panel, Chairperson Born of the CFTC, to come to the table.
    Thank you very much for being here, and please proceed.
STATEMENT OF BROOKSLEY BORN, CHAIRPERSON, COMMODITY FUTURES TRADING COMMISSION
    Ms. BORN. Thank you very much. Mr. Chairman and members of the subcommittee, thank you for providing the Commodity Futures Trading Commission with an opportunity to discuss agricultural trade options before the subcommittee today.
    I am confident that today's hearing will have a dual benefit: informing the subcommittee about an issue important to the agricultural community and assisting the Commission in its current consideration of whether to lift the ban on agricultural trade options.
    Accompanying me here today are Commissioners John E. Tull, Jr., Barbara Pedersen Holum, and David D. Spears.
    My testimony on behalf of the Commission will focus on three areas: a history of options on agricultural commodities; a discussion of the Commission's staff White Paper on agricultural trade options; and a description of the Commission's process for reviewing whether or not to lift the ban on agricultural trade options.
    Options are transactions that grant one party the right, but not the obligation, to buy or to sell a commodity or other interest at a fixed price. Options trading can be broken down into two broad categories, exchange-traded options and off-exchange options.
    Trade options are a kind of off-exchange commodity option which can be offered only to a commercial person or entity solely for purposes related to that person or entity's business. Trade options are currently prohibited on certain agricultural commodities listed in the Commodity Exchange Act, although they are permitted on other commodities.
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    If agricultural trade options were to be permitted, a corn farmer could purchase an option from an elevator to sell the farm's anticipated production of corn at a certain price. Similarly, a wheat miller could buy an option to purchase wheat from a grain dealer for processing at a certain price.
    Agricultural options were traded in the United States at least from the time of the Civil War until the 1930's. However, concerns about fraudulent sales practices, failures to perform over-the-counter obligations, and the use of exchange-traded options to manipulate the prices of agricultural commodities prompted numerous industry and government efforts to limit or to eliminate trading in such agricultural options.
    In 1936 Congress banned all sales of options on certain agricultural commodities listed in the Commodity Exchange Act. Today those listed commodities include the major grains, oilseeds, cotton and livestock products, among others.
    Congress's ban did not apply to all commodities, and fraud and abuse in options markets in non-listed commodities, such as gold, was one of the reasons for creating the Commodity Futures Trading Commission in 1974.
    The 1974 amendments to the Commodity Exchange Act vested the Commission with broad-based authority over both on-exchange and over-the-counter options markets in non-listed commodities, but left in place the 1936 options ban on the listed commodities.
    Shortly after its creation, the Commission adopted rules that exempted over-the-counter trade options in non-listed commodities from most regulatory requirements. However, the Commission did retain power to enforce fraud and manipulation prohibitions as to such trade options.
    Despite historical problems associated with commodity options, there remained considerable interest in their use. Accordingly, in 1981 the Commission instituted a pilot program for exchange trading of commodity options in commodities other than the listed agricultural commodities.
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    In 1982 Congress lifted the 1936 statutory ban, thus allowing the Commission to permit options in listed agricultural commodities. The Commission permitted exchange trading in these agricultural options in 1984. However, the regulatory ban on agricultural trade options was maintained.
    The reintroduction of exchange-traded commodity options has been a commercial and regulatory success. Neither they nor trade options on the non-listed commodities have posed unusual regulatory problems.
    Although the Commission has considered lifting the regulatory ban on agricultural trade options several times during the past 15 years, the Commission has not acted to reintroduce trade options on the listed agricultural commodities, choosing instead to leave the ban in place.
    There have been deep divisions within the agricultural community on these issues. Opponents of lifting the ban have expressed concerns over possible fraudulent activity and suggested that such contracts might result in confusion in the producer community. Nonetheless, there have also been repeated calls throughout the years for the Commission to permit broader use of trade options in the agricultural sector.
    Earlier this year, the Commission asked its Division of Economic Analysis to prepare an analysis of the issues surrounding agricultural trade options. The Commission's request in part reflected increased producer interest in additional risk management tools in light of the significant changes in U.S. farm policies enacted in the 1996 Federal Agricultural Improvement and Reform Act or the FAIR Act.
    In May 1997, the Divisions staff completed a White Paper entitled ''Policy Alternatives Relating to Agricultural Trade Options and Other Agricultural Risk-Shifting Contracts,'' a copy of which is attached to our testimony.
    The White Paper analyzes the current regulatory environment, recent developments in agriculture that have expanded the need for risk-shifting strategies, the benefits and risks of agricultural trade options, and possible ways to strike a balance between such benefits and risks. Based on this analysis, the White Paper concludes with a series of staff recommendations for the Commission to consider.
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    A central benefit identified in the White Paper is that lifting the ban on agricultural trade options potentially would provide producers and other commercial entities with a greater variety of risk management tools. Other benefits derive from customization to meet particular needs.
    Customized options would permit more precise matching of hedges to amount, timing, quality, and other commodity characteristics. The White Paper additionally cites benefits from increased competition, such as the potential increase of the supply and variety of agricultural options and possible lower costs to users.
    The White Paper also describes various risks associated with trade options, and six risks are highlighted in the White Paper: fraud, credit risk, liquidity risk, operational risk, systemic risk, and legal risk.
    The White Paper suggests that the Commission should consider whether to lift the ban subject to appropriate regulatory conditions. Three categories of conditions are discussed in the White Paper: restrictions on eligibility of the parties; restrictions on the instruments and their use; and regulations on the marketing of the instruments.
    Based on the White Paper, the Commission decided to seek public comment on whether or not the Commission should lift the ban and, if so, what regulatory conditions would be appropriate.
    A Federal Register notice dated June 9, 1997, requested interested persons to address a number of specific questions that would assist the Commission in its deliberations on whether to issue a proposed rule to lift the agricultural trade option ban. A copy of the Federal Register notice is attached to our testimony. Written comments are due to the Commission by July 24, 1997, tomorrow.
    The Commission has just completed two field meetings on the subject. All five of the Commissioners attended the meetings in Bloomington, IL, and Memphis, TN. The statements by interested persons at the meetings were very thoughtful and informative.
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    After analyzing and considering all public comments, the Commission will determine whether to propose a rule lifting the ban on agricultural trade options. If it were to decide to do so, the proposed rule would be published, and public comment on the proposal would be solicited and considered prior to any Commission determination on whether or not to adopt the rule.
    The Commission is committed to considering this important issue carefully in light of the history of options trading, the increasing need for price risk management by agricultural producers, the views of all interested persons and a thoughtful weighing of the risks and benefits.
    Thank you again for this opportunity to appear before you today. The Commission continues to look forward to working with you on this matter and on other important matters. Thank you.
    [The prepared statement of Ms. Born appears at the conclusion of the hearing.]
    Mr. EWING. Thank you, Chairperson Born. If you wish you may call on your staff or your other Commissioners if you want them to either join you at the table or to answer questions.
    We heard a lot last year or the last couple of years about the hedge-to-arrive. How different is this from the hedge-to-arrive agreements that caused us some problems in the past?
    Ms. BORN. Well, the term hedge-to-arrive has been applied to a very wide range of contracts, many of which are completely legitimate, merchandising contracts, including forward contracts. Some of these contracts, however, may be illegal off-exchange futures contracts or illegal off-exchange options contracts.
    What we are talking about here is a much narrower kind of instrument, merely an option agreement entered into by a commercial person. There may be some illegal HTA contracts which would meet the definition of an agricultural trade option and which, in the future, if the Commission decided to lift the ban, would be permitted.
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    Mr. EWING. So the real distinction is the element of a futures contract over a contract that wasn't a futures contract when they had a futures contract off-exchange that would have been illegal under hedge-to-arrive?
    Ms. BORN. That's one kind of illegal contract. Also, an off-exchange options contract is currently illegal and has been since 1936.
    Mr. EWING. If you were to lift the ban, do you anticipate that it would be with some restrictions and requirements and definition of the types of contracts that could be offered?
    Ms. BORN. That is certainly what the Commission is currently considering, whether or not to lift the ban with regulatory conditions and, if so, what the appropriate regulatory conditions would be.
    Mr. EWING. What did you hear when you were in Illinois and Tennessee?
    Ms. BORN. Well, there were a wide range of views, ranging all the way from suggestions that we should immediately lift the ban on agricultural trade options with no regulatory protections to suggestions that, under no conditions, should we lift the ban.
    One aspect of the testimony that interested me, however, was how many of the people who were speaking were suggesting that regulatory conditions were important. Some people were saying that we should not lift the ban without regulatory conditions. Others were saying we should lift the ban with regulatory conditions, and I was surprised at how close those people were in their views.
    Mr. EWING. In numbers of people that said lift the ban, don't have regulation or lift the ban with regulations?
    Ms. BORN. How many people thought, if we were to lift the ban, regulations were important.
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    Mr. EWING. You didn't hear from any producers, at least in the Illinois hearing?
    Ms. BORN. I'm not certain whether Lloyd Metz is a producer, but he did testify. There were also a number of groups that testified who represent producers.
    Mr. EWING. Well, I believe Mr. Metz, whom I know, is a farm owner, if not currently active producer, but what I meant was you heard more from organizations and groups, more than individual producers who might have availed themselves of the hearing?
    Ms. BORN. That's correct.
    Mr. EWING. Was Tennessee much the same?
    Ms. BORN. There again participants tended to be groups, although there was a grain elevator operator, for example, who testified. I don't think any individual producer testified, at least on his own behalf as opposed to on behalf of an agricultural organization, in Memphis.
    Mr. EWING. It would seem logical that maybe producer groups and farm organizations would be more in tune to come to a hearing and to present their views than maybe a wide array of producers. But I wonder, does that give us any idea that this isn't widely acclaimed as a solution or a good idea or do you think that it really doesn't reflect on the amount of support out there among producers?
    Ms. BORN. Well, to a large extent, I think we need to rely on agricultural organizations who represent the producer to tell us how interested their membership is, and we had varying testimony from different producer groups.
    I suspect that perhaps more publicity is needed and that more ground work is needed to get a lot of individual producers to a meeting. We were very sorry about that, because we had chosen to have the meetings in Illinois and Tennessee in hopes of reaching more individual producers.
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    Mr. EWING. My time is up, and we will have another round of questions, if your time permits. So I'll go to Mr. Baldacci, but for those in the audience, the hearing in Illinois was in my Congressional district, and we were very pleased to have the CFTC hold the hearing there, and that's why we have some connection with the mutual people who may have testified.
    Ms. BORN. Well, we certainly received very warm hospitality.
    Mr. EWING. And you found it was the finest corn producing area in the world.
    Ms. BORN. I was extremely impressed, Mr. Chairman.
    Mr. EWING. Mr. Baldacci.
    Mr. BALDACCI. Next to Maine. Thank you very much.
    I want to thank you for your testimony. After reading some of the testimony, the only question I have at this time—and a statement. There's reference to a flex option, and there's a feeling that in some of the testimony that the flex option that's available may, in fact, be able to do the same thing that people are trying to do in opening up the market more.
    Do you have any comment?
    Ms. BORN. I think what you're referring to is a kind of exchange-traded option. I don't think it's available in any of the agricultural products at the moment, although it is available in one or two non-agricultural products.
    Let me just check with my staff to ascertain if that's correct. Yes.
    Mr. BALDACCI. The issue that was raised in the testimony that I was reading said that people believe that it may be a great mistake to remove the ban on agriculture trade options, particularly when exchange-traded instruments could provide the same benefits to users with less risk under the current regulatory structure.
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    Based on its past experience with these off-exchange instruments and unique characteristics, they are urging the Commission to review that. Now what are those exchange-traded instruments, and could they accomplish the same goals?
    Ms. BORN. I suspect there are standardized exchange-traded options in a number of agricultural commodities. There are not currently any flexible options in those agricultural commodities, although the exchanges may be considering that and trying to design them. We have not had any submitted to us for approval. However, it's clear that there are not exchange-traded options on all agricultural products.
    One of the reasons that we are being urged by producer groups to consider lifting the ban on agricultural trade options is that some producers and other commercial people do not have exchange-traded options that fit their particular products. It may also be that the exchange-traded standardized contracts—even if the farmer or producer happens to be producing that particular product—are in too large a quantity for the producer to use or the producer may need other customization of the contract to fit his or her needs, which is currently not available on exchange.
    Mr. BALDACCI. In regards to the legislation that the Congress passed in the 104th and in terms of Freedom to Farm and, hopefully, the ability to be more market oriented, that agriculture would have the tools in order to properly manage in that kind of an environment with proper safeguards. I just wanted to make that statement.
    Thank you, Mr. Chairman.
    Mr. EWING. Mr. Smith.
    Mr. SMITH. In your proposed rule—and I apologize for not being totally familiar with the proposal, but are you suggesting there still be CFTC oversight of some kind—if you were to allow these trade options? Would CFTC still have a role in examining and setting up whatever safeguards there might be?
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    Ms. BORN. We haven't promulgated any proposed rule yet. All we've done is ask for comment from the public as to whether or not we should consider a proposed rule that would lift the ban subject to appropriate regulatory conditions, presumably imposed by the CFTC, and if so, what those regulatory conditions should be.
    So essentially at this stage, the Commission is seeking public input as to whether or not we should draft and propose a rule.
    Mr. SMITH. Anyway, Chairman Born, I am delighted to see you again, and delighted to have you and the other Commissioners before this committee. I wonder, are there experts? Are there universities or other trade marketers or has there been other research into the consequences of opening this up for additional speculation?
    I mean, already I am nervous about those gambling on the market are probably more involved than those actually buying and selling the commodity. So if we open up these trade options, it seems to me that we're inviting additional speculation from non-involved parties.
    Ms. BORN. Well, these would be trade options, which would mean that they could only be offered to commercial persons, meaning producers or processors or merchandisers of the commodities, as opposed to speculators; and they could only be used by those people for business purposes, for example, hedging or very closely related purposes, not for speculation.
    Mr. SMITH. Then who would oversee and assure that it was a business related trade option?
    Ms. BORN. Well, we do that right now for trade options in all commodities other than the listed agricultural commodities and we've done that since the seventies, late seventies.
    Mr. SMITH. As I think I've mentioned to you before, I have a concern that what I would like to call normal farmers, family farmers, have less of an option to use the commodity futures market, and that is certainly in contest to justification for why the commodity exchange was developed in the first place.
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    So as I see a lack of use by farmers to use the commodity futures with a true hedge, depending on whether they are selling or buying, I'm concerned that maybe we should be reviewing the rules and the procedures that would encourage the commodity futures market to be a better tool in marketing.
    What would be your opinion of expanding these trade options to those farmers? Would that help?
    Ms. BORN. Well, one of the things that we are hearing from some producer groups is that there is a percentage of producers who are reluctant to deal on the exchanges and would prefer to get risk management instruments from their local grain elevators, for example, the people that they deal with in merchandising their product. Agricultural trade options would, for the first time, permit that kind of transaction.
    Mr. SMITH. And who would be the most frequent users, if these options were either moved ahead on a pilot basis or some kind of a permanent basis? Who would be the users?
    Ms. BORN. Well, the interest that we've heard to date, I think, is primarily in the grains, soybeans, cotton, and livestock, and it would be producers and other people in the commercial area——
    Mr. SMITH. What was the catalyst or stimulus that made the Commission decide to put this proposal forward? Is there ongoing pressure all the time?
    Ms. BORN. Again, we don't have any proposal. We're just asking whether we should do this.
    Mr. SMITH. Have you done this in the past? Since 1936, have we explored this before and decided no?
    Ms. BORN. It's been explored on a number of occasions in the last 15 years. In 1991 the Commission proposed to lift the ban, but never finally adopted the rule. It did propose a rule to lift the ban without regulatory protections except fraud and manipulation prohibitions. That was not adopted.
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    More recently, we have begun to hear from a number of producer groups that, particularly in light of the FAIR Act, producers are feeling they need a bigger range of risk management tools, and these interest groups feel that agricultural trade options would provide an additional tool.
    Mr. SMITH. Thank you, Mr. Chairman.
    Mr. EWING. Mr. Boswell.
    Mr. BOSWELL. Thank you. Just briefly, do you have any thought or feeling about measuring this for a short time at least with a pilot program or a limited group, or what's your thoughts on that?
    Ms. BORN. Well, when we were in Bloomington and Memphis, we heard a number of the commentators before us recommending that, if we do lift the ban, it should be done on a pilot program basis only, and that certainly is one of the issues that we are seriously looking at.
    Mr. BOSWELL. How serious?
    Ms. BORN. Again, we haven't decided whether to even propose a rule that would lift it.
    Mr. BOSWELL. If you were to proposal a rule, how serious?
    Ms. BORN. If can provide you with my personal views, because the Commission has not deliberated on this at all. We have just been listening and receiving comments.
    I personally would feel, if we go this way—and I haven't decided if I will feel comfortable going this way or not—that a pilot program would be an appropriate way to introduce this and see whether the risks are undue.
    Mr. BOSWELL. I guess I'm off the script a little bit here, but if you propose it and if you do a pilot project, have you got any thought that just comes off the top of your head on what size of pilot project that will be?
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    Ms. BORN. We did get comment from at least one producer group that—and I think that was the National Cotton Council—that they felt that it should be broad based in terms of the commodities included, and that they would certainly want cotton included, although they weren't in their testimony urging us at this point, because I don't think they have decided whether we should in fact go forward.
    I would think that a limited period of time, something like three years, would be appropriate, and with some very careful regulatory provisions, if we were to go that way; for example, possible limitations on the kind of entities that could offer options.
    Mr. BOSWELL. Well, thank you. I think it would be fair if you were to reverse the question. As I have traveled across the district out there, Mr. Chairman, I find some producers that would really like to do this, but with some restrictions, careful, and others that are afraid to touch it because of what the Chairman mentioned with the HTAs. I appreciate your comments. Thank you very much.
    Ms. BORN. Well, as I mentioned, the major impetus in terms of expressions of interest seems to be grain, cotton, livestock, soybeans.
    Mr. EWING. Mr. Pomeroy.
    Mr. POMEROY. Thank you, Mr. Chairman.
    Madam Chairperson, it's good to see you again.
    Ms. BORN. Thank you.
    Mr. POMEROY. The actions of this committee have consequences, and a year ago we voted to repeal price support, something that had been a feature of our agriculture landscape and official policy toward agriculture for decades. That leaves the family farmers I represent subject not just to the vagaries of production but also without protection to the significant price swings the market brings about.
    Under those circumstances, risk management tools privately available are critical, and I think that the work of the Commission in moving forward in this area for the first time in 60-plus years but doing so in a thoughtful way is excellent.
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    I don't know what industry or related industries could want more than an official invitation to discuss, which is essentially what your initial rule—or whatever you call it——
    Ms. BORN. Advance notice, we call it.
    Mr. POMEROY [continuing]. Your advance notice invites. I hope the input has been productive.
    Ms. BORN. It has.
    Mr. POMEROY. Good. I also like this briefing, because I feel like it's extremely timely, early. Often we're told about things when all is done, and the fight has ensued, and we're trying to sort out what we can't even begin to sort out. So very good work up to this point.
    Will you help me, just in terms of understanding. You note on page three of your testimony exchange trading in agriculture options allowed since 1984, but the ban on agriculture trade options being maintained. I know there's a term of art there. I'm just not quite sure I fully understand what's within that.
    Ms. BORN. Trade options are a kind of off-exchange option. Generally, off-exchange options are prohibited by law, while exchange traded options are now permitted. However, since the late seventies the Commission has allowed an exception from the ban on off-exchange options or what are called trade options in non-agricultural products.
    Trade options are options that are offered to a commercial person for purposes of that person's business only, and so, for example, in the energy area, in metals, in other non-agricultural products, indeed in the tropical agricultural products like coffee and sugar and cocoa, it's been permitted since the late seventies for commercial people to have off-exchange options.
    Mr. POMEROY. Regulatory protections seem almost—regulated off-exchange activity almost seems like an oxymoron. I mean, is there a regimen of regulatory protections being developed for off-exchange activity that might have some application to a newly created off-exchange market for agriculture?
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    Ms. BORN. The only regulations that have been applicable in the last 20 years to off-exchange non-agricultural trade options have been prohibitions on fraud and manipulation. What's really considered at this point, because of the long history of fraud and overreaching in the agricultural off-exchange option area, is a more comprehensive regulatory approach than just the bare bones fraud and manipulation prohibitions.
    Mr. POMEROY. Again, thank you for that explanation. It's helpful, and I wish you well in your ongoing evaluation of this activity.
    I'm inclined to think that it's a very positive step, and to the extent you have a well considered pilot, I hope you look to the upper Great Plains as a place you might want to try one out. Thank you.
    Ms. BORN. Thank you.
    Mr. EWING. Mr. McIntyre, do you have any questions?
    MR. MCINTYRE. Not at this time.
    Mr. EWING. All right. I'm going to ask a few more, and so if you choose to ask after you've listened to the discussion for a while, feel free.
    During our April discussion about the idea of Commodity Exchange Act reform, your Commission expressed concern about the pro market proposal that's in that piece of legislation. I realize that is not before us today, but in your White Paper you wrote about it. I think you say one means of addressing several of the risks noted above would be to impose eligibility limitations such as to restrict the availability of agricultural trade options to sophisticated individuals or entities to require those selling those instruments to be registered with or identify themselves to the Commission or be commercial themselves.
    Sounds a little bit like the definition of pro market. I just wondered how you might address the difference, if you were less enthusiastic about pro market for the exchanges and this comment here in your paper.
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     Ms. BORN. I think that comment is in not a Commission document but a document of the Division of Economic Analysis of the Commission. So that's their views, but let me just say that the Commission's opposition to the professional market proposal in the bill that's pending before the House is that it eliminates CFTC regulation over exchange trading.
    What we are now considering is what the appropriate regulatory regime should be if we permit over-the-counter, bilateral trade options in agricultural products. I think the Commission's views on this are essentially consistent.
    Obviously, we haven't taken a position on trade options yet, but the Commission believes that markets need to be regulated with an appropriate regime, depending on the risks and nature of the particular market. These two markets would be quite different.
    Exchange trading does involve important price discovery functions. So Government prevention of manipulation and price distortion is critically important for those markets. They are the basis for trillions of dollars of commercial transactions in agriculture and other products in this country.
    On the other hand, over-the-counter options are bilateral. The problems haven't been historically that they create price distortion, because they tend to be very small transactions; but there has been a tremendous history of fraud and overreaching, and also there's a danger there of the creditworthiness of the two parties to the contract, which you don't really face on an exchange because of the clearinghouse.
    So the issue, in the Commission's view, is what an appropriate regulatory regime for the particular market is, and that's what we're trying to figure out with respect to agricultural trade options, if we were to permit them.
    Mr. EWING. I believe the words are somewhat maybe subject to different interpretation, but the Division of Economic Analysis by the Futures Exchange Commission is an arm of your Commission.
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    Ms. BORN. It's part of our staff.
    Mr. EWING. Yes. You wouldn't put out an analysis that you didn't have some confidence in.
    Ms. BORN. Of course not, and we have a lot of confidence in them, but the purpose of that paper was to suggest a number of possible approaches to regulation of agricultural trade options. One of the possible regulations would be to insist that only sophisticated or high net worth entities could participate.
    That proposal actually has gotten a great deal of criticism in the comments that we've received on the grounds that it would unfairly limit the risk management usefulness of this tool to only large producers and not to many of the farmers who need it.
    Mr. EWING. You commented that you had not made a decision on what to do with lifting this ban. I know that Commissioner Joe Dial was quoted as saying that he hoped the ban would be lifted by October.
    Now Mr. Dial is in the room, and maybe you don't want to speak for him, but is that just a personal opinion or does he have some inside information?
    Ms. BORN. Commissioner Dial couldn't be with us today. I know that he's very sorry about that, because this is very near and dear to his heart. I think that Commissioner Dial would like the Commission to reach a decision whatever that might be as quickly as possible.
    I think that the Commission as a whole will need to move carefully. We will have all of our public comments, hopefully, by the end of the day tomorrow, but then I think we all have to analyze this and make a careful decision. That is not the final stage either. Our first decision needs to be whether to promulgate a proposed rule and, if so, what it should say.
    Mr. EWING. One other question. One of the recommendations is a proxy limitation that would set a minimum transaction size, preventing smaller, less sophisticated individuals from participating. I wonder if this recommendation would really hinder the ability of this to be a risk management tool out in farm country where we're certainly going to be dealing with some smaller producers.
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    Ms. BORN. It might well, and that's one of the things we're looking at. The thought here or the concern, I think, that our Division of Economic Analysis was addressing is that options are very complex instruments and can be extremely complex instruments.
    Because there's been a ban on them for 60 years, there isn't any experience in the producer community with using these instruments, and one of the issues that we need to look at carefully is how can we assure that people who might use these instruments really understood their nature and were appropriately educated on that.
    Mr. EWING. Thank you very much. Mr. Smith.
    Mr. SMITH. Just in following up on the chairman's thoughts, I helped write in a lot of the risk management language that went in the FAIR Act, and it seems like education is very important, if you proceed with this kind of pilot program, and I hope it would be a pilot.
    It seems like education is still a part of it, but considering that these kind of options in some regards could be a substitute for such things as the HTAs, it seems to me that the HTAs that are available to everybody and, if you're going to use them, you better know what you're using, is no different than these kind of options.
    So it would be my recommendation or my feeling that you can't limit it to the small producer, but you can be somewhat more aggressive in working within FTC and the different commodity exchanges and with Ken Ackerman or whoever over at USDA and making sure that we develop the kind of information programs that's going to help all producers use this; because it is important that those kind of tools be available to all farmers as we proceed in this new venture of letting farmers decide how much of what crop to plant.
    So I just make that comment. I don't know if it deserves a response.
    Ms. BORN. Well, the Commission is currently cooperating with USDA and Mr. Ackerman in USDA's efforts to institute an education program.
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    Mr. SMITH. Thanks, Mr. Chairman. That's all I have.
    Mr. EWING. Thank you. Mr. Condit, our ranking member.
    Mr. CONDIT. Madam Chairman, I'm glad you're here. Let me just ask a couple of questions, and I apologize for being late. If you've already responded to them, I can certainly find them in the record.
    In your study did you find that entities which will offer trade options are commonly subject to any regulations regarding their financial status or strength?
    Ms. BORN. Really, at this point we are trying to decide whether to allow any entities to do that and, if so, whether there should be minimum net capital requirements, for example, or other financial requirements on entities offering producers and other commercial agriculture interests options.
    Mr. CONDIT. Does the Commission have before it the possibility of lifting the ban on any kind of pilot basis, either limited by the crop or geographical region?
    Ms. BORN. Yes. We are considering a whole range of possibilities, if we were to lift the ban as to how we would lift it.
    Mr. CONDIT. I think that's all I have right now, Mr. Chairman. I have some other things that I might submit for the record as well as a statement.
    Mr. EWING. Thank you very much, Commissioner Born, for being here, and I hope that you can stay and listen to the second panel on our hearing today.
    Ms. BORN. I plan to.
    Mr. EWING. Thank you again.
    Ms. BORN. Thank you.
    Mr. EWING. I would say, as I ask the second panel to the table, that I was playing favorites with the Chairperson, and we didn't have the 5-minute rule, but with the bigger panels we will ask to follow the 5-minute rule.
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    The Chair would also like to ask witnesses to remain and be available until we complete the hearing, which we do not anticipate to be too lengthy. The Chair would note that the National Farmers Organization, the American Cotton Shippers Association, the National Cotton Council of America, and the American Soybean Association have all submitted testimony for the record.
    [The statements appear at the conclusion of the hearing.]
    Mr. EWING. I would now like to call the second panel to come forward to the table. I would welcome John F. Sandner, chairman of the Chicago Mercantile Exchange; Andrew Whisenhunt, president of the Arkansas Farm Bureau and representing the American Farm Bureau Federation; David Lehman, chief agriculture economist, Chicago Board of Trade; Kendell Keith, president of the National Grain and Feed Association; Harold M. Reed, general manager, grain division, The Andersons, Inc.; and Paul J. Gregory, president of the National Introducing Brokers Association; Ms. Nancy Danielson, legislative representative, National Farmers Union.
    Welcome to all of you. Thank you for participating, and we will start with you, Mr. Sandner.
STATEMENT OF JOHN F. SANDNER, CHAIRMAN, CHICAGO MERCANTILE EXCHANGE
    Mr. SANDNER. Thank you, Mr. Chairman. I've been here many, many times over the last 17 years and, more recently, over the professional market and the new legislation that you have introduced. This isn't too unlike some of the things that have been going on, as you mentioned in your question and answer, on pro market and the other issues before us.
    Basically, it's regulation versus deregulation, and it's a philosophical issue that must be dealt with and attended to, and this isn't, as your questions indicated, something that is too far different than from what you've already been dealing with over the last couple of months. Without splitting hairs, it's very much a philosophical issue about regulation versus deregulation.
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    I really thank you for giving me the opportunity to testify and really welcome this opportunity, because in this area especially, I don't think there should be much confusion or obfuscation of these issues, because there is absolutely a record that is replete with this type of an issue in terms of options and a history that is very, very clear.
    That history and that record will indicate, going back, as Chairman Born indicated, to the Civil War times, all the way to 1936 and after, indicates pure and simply abuse and more abuse in this area, fraud and more fraud in this area. I won't go through the history, beginning in Civil War times to 1936 and after, because Chairman Born has already done that in a very, very adequate way, but that history is clear that everyone has had difficulty approving these things because of all the abuse it has lent itself to.
    We oppose vehemently the lifting of the ban on agricultural options, and I'm going to give you as simply as possible in as brief a time as possible the reasons why.
    There is this history of fraud, and we don't see what has changed. There is nothing changed that wouldn't produce that, and I'll indicate to you why we feel that it would happen again. I think we should learn from history, and I won't quote who gave the original quote, because I don't know who it was, but if you don't learn from history, you're doomed to repeat it.
    Why does it happen? It happens because the individuals that are able to be approached are easy prey, for a number of reasons, that there is no centralized market that one can really balance these types of instruments against to see that they are being adequately priced. They are qualitatively different in terms of all the things that they portend to do in the pricing of those things, because there is no centralized market.
    There is no real competition for commission structures, because there is no centralized area to check whether the commission structure in these things are being fairly charged, and because of the basic problem of no centralized market where these things can be traded, it produced a lot of fraud. It produces that in pricing and commission structures and, ultimately, because there's no counter-party risk protection, it ultimately produces the final blow, and that's a default, because unlike the exchanges, there is no one guarantying counter-party risk.
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    Witness, as was mentioned continually through the hearing earlier, the hedge-to-arrive contracts and what has happened there. The counter-party risk: nobody guaranteed the counter-party risk, and Chairman Born said it very appropriately, that at the exchanges the counter-party risk is taken care of.
    So notwithstanding the fraud that occurs in pricing and in commissions, no transparency to the marketplace, because there's no centralized market, you also have a counter-party risk that's not attended to.
    So for all these reasons, we're against it. Now we hear that there are groups that say they want it for a number of reasons. The best that I've heard is that perhaps the exchange isn't able to address some of the customized type of things that they need done in their products, and I'd like to address that in a minute, but I would like to clear the record on that.
    Our exchange is meeting those challenges. We are trying to define those needs as carefully as possible to see if there are truly the needs out there and it isn't just one entity that needs something. We're going to be introducing flex options, which was suggested by one of the other Congressmen earlier, I think Congressman Baldacci.
    We're going to be introducing those in the next several months in terms of our Research Department producing what we think needs to be produced and then submitting them to the CFTC. So we think we will be addressing that need, if we've really defined that that need is out there; but even the National Farmers Organization that might say at first blush in their testimony that they have submitted that, yeah, these will be a good idea to add to the competitive landscape, but at the same time we want a lot of safeguards. We want it to be regulated by the CFTC or the SEC. We want financial safeguards that the people have the wherewithal to meet their obligations. We want full risk disclosures. We want audits of these entities, and we want audit trail, and we want record keeping.
    We want all the things, basically, that are already there in place at the exchanges. Except it's a lot easier, even though it's difficult for the CFTC to do all of those things, even when our marketplace is centralized and arteries are spawned out of the centralized marketplace so there can be a tracking of the people trading it.
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    There's no way to do that in an uncentralized market. There is just absolutely no way to do that. In fact, it's impossible. That market is fragmented when it's decentralized. There aren't any standardization of these products. They are exotically engineered. There's no way to go for them in the corners of your productive area, your jurisdiction in Illinois. There's no way to go into Iowa. There's no way to go into these places where these things are being done in an uncentralized way.
    I just got back last night at one in the morning from a very lengthy trip, part of which was business in Prague, in Bucharest and in Sophia, Bulgaria, and they talked with me about—because they have agricultural products. They have things that they want to do, and they suggested things that are being done out there is causing them grave concern, and they're all being done in a decentralized way, and those are the things that really spawn and create the environs for fraud and disparity in pricing.
    That's why centralized markets and multi-lateral execution between parties and counter-party risk are very important issues to attend to.
    The consequences when these things will happen are not of no consequence whatsoever, because what it does to our exchanges is it creates an irreparable harm and a loss of public competence in risk management, when it's needed more than ever today when it was suggested by the Congressman earlier on price supports—I think it was Congressman Pomeroy—about price supports being gone.
    So risk management is needed more than ever today. Education is needed more than ever today to handle these risk management issues for farmers and agricultural producers, and the consequences are, when fraud happens out there, as it happened with the hedge-to-arrive contracts, that the public confidence in risk management is dissipated to the point that, even on our exchanges, liquidity will be affected, and without liquidity you can't have adequate pricing. You can't have bid and offers that are tight, so that these farmers can have ingress and egress to the marketplace with a deep bid and offer at a price that makes sense to them.
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    When liquidity is impacted, price discovery is impacted. Price transparency is impacted, and you do irreparable harm to a marketplace.
    We've invested millions and millions of dollars over many years developing the systems to create a marketplace that allows risk management to take place in a nurturing way, at the same time giving the protections where these things don't happen.
    They will happen over-the-counter. There's no question about it. The cure is in regulation and audits by the CFTC, because they can't possibly do it. You've had testimony over the last number of months to increase the budget of the CFTC to monitor practices in a centralized market. How in the heck can the CFTC expand their regulatory jurisdictional structure to really do the compliance, the audit trails in a decentralized market in the corners of Iowa and Illinois and other agricultural states where this would be spawned.
    The challenge for the exchanges, however, is to produce, if the need is really out there, the flex type options that address some of the customer needs of the farmer. So we strongly oppose it, and we think that the lift on agricultural trade options—on that ban, which was put in place at the beginnings of 1936 and revisited time and time again, should not be lifted.
    Thank you very much for the opportunity, Mr. Chairman.
    Mr. EWING. Thank you, Mr. Sandner.
    [The prepared statement of Mr. Sandner appears at the conclusion of the hearing.]
    Mr. EWING. Mr. Whisenhunt.
STATEMENT OF ANDREW WHISENHUNT, PRESIDENT, ARKANSAS FARM BUREAU, AMERICAN FARM BUREAU FEDERATION
    Mr. WHISENHUNT. I want to express my appreciation personally and on the behalf of American Farm Bureau for the opportunity to testify here today. We do have written testimony that's presented, and I am here to represent the 4.7 million members of American Farm Bureau.
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    Many of these are production agriculturists, and they range in size from the very small, part-time farmer to the large commercial operations.
    We want to give you what is the result of our policy development process and the resolutions that were brought in and the support from our membership saying that we would like to have the ban lifted. However, we believe it appropriate to impose certain conditions on the sellers of agriculture trade options, even though trade options of non-enumerated commodities are exempted from all of the requirements applicable to off-exchange commodity options except for rules prohibiting fraud and manipulation.
    AFBF expects a number of benefits to result from lifting the ban. One benefit is likely to be an increase in the supply of, and competition in offering, option contracts. Currently, the only options available to producers are standardized, exchange-trade options. We believe that lifting the ban would enable development of customized contracts and financing arrangements.
    Agriculture trade options may allow a producer to better manage his business risks. In addition, many hedgers may be more comfortable in relying on established cash markets for risk management. These traditional, established cash trading partners often have a greater understanding of the hedger's marketing position and risk management needs than others.
    These cash trading partners may, therefore, be better suited to recommend particular hedge strategies and contracts. Elevators and other first-handlers could offer contracts with terms, product specifications or financing arrangements more closely tailored to the hedging or other needs of the customer.
    Trade options allow a hedger to specify expiration or delivery dates coinciding with harvest dates, processing schedules or the timing of forward contracts. This reduces a hedger's exposure to the risk from mismatching the expiration date of an exchange-traded contract.
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    Basis risk also can be reduced for the hedger by allowing a closer match to the grade of the crop or livestock at a particular delivery location. Customers, through the bundling of various options, can also gain access to contracts which hedge multiple risks.
    The way the current agriculture trade options ban is administered harms the very producers it purports to protect. There are glaring inconsistencies which clearly work against producers. For example, in the cash grain trade, a grain-offer contract between two grain merchandisers is legal, but if a producer is paid for that call-away right, it's illegal.
    Commercial trading of barges and cargoes of grain is legal, but producer buy-back of delivery contracts is considered unacceptable. Buy-sell agreements between commercials are common and legal. The same activity by producers is prohibited.
    It appears that, under the current regulatory system, legality is based on who is doing the trading or contracting or why it's being done. Unfortunately, producers are, for the most part, prohibited from using the same risk management tools that are available to others further up the marketing stream.
    Trade practice already allows the use of trade options beyond the producer. Furthermore, agriculture is the only industry where producers have been singled out as being in need of government protection.
    It is inappropriate to automatically associate trade options with increased complexity. It is the ban on trade options which prevents simple risk management tools from being developed. Many of the problems which arose with the hedge-to-arrive contracts would not have occurred if walk-away contracts had been available.
    It should be acknowledged that agriculture trade options would trade in a less regulated environment than exchange traded options. Decentralized trading would preclude the establishment of active surveillance. What's more, the burden of market performance would be on the trading counter-parties.
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    Customization of contracts does increase the possibility of fraud and will make the oversight policing of trade practices more difficult. However, we believe that the probability of fraudulent activities is not significantly different than that which currently exists in cash and futures markets, especially if agriculture trade options writers were required to be registered with the CFTC or an appropriate trade association and if the CFTC established regulatory requirements for periodic reporting of account positions by option writers.
    We believe it is appropriate for the Commission to establish minimum financial standards for writers of agriculture trade options to guard against the risk that a counter-party will be unable to meet an obligation. Less stringent financial requirements could be set for writers who restrict exposure to levels consistent with their cash market activities and for those whose exposure exceeds such levels.
    In addition, it may be sufficient for the minimum financial requirement for agriculture trade option writers to be met by meeting minimum financial standards which already exist for the industry; in other words, state and Federal banking standards already set minimum financial and risk exposure standards.
    federally licensed warehouses have minimum financial standards. A bank, grain elevator or an insurance company that is an agriculture trade option writer and who meets those industry standards for capital reserves and risk exposure may be deemed to have sufficiently met the minimum financial standards for writing agriculture trade options.
    We believe that it is appropriate for the CFTC to establish registration and education criteria for agriculture trade option vendors. More detailed information on these criteria is contained in our written comments. However, we believe that it would be very appropriate for the CFTC to require a substantial risk disclosure statement and that it be publicly displayed on the agriculture trade option contract which involved the writing of puts or calls by exposure to margin.
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    Agriculture is changing, and our people are in a new age under a new farm bill. They are subject to the risks that have been given to us. We are ready to use it. We just simply want the opportunity.
     Thank you, sir.
    [The prepared statement of Mr. Whisenhunt appears at the conclusion of the hearing.]
    Mr. EWING. Thank you very much.
    Mr. David Lehman, chief agriculture economist, Chicago Board of Trade. Welcome.
STATEMENT OF DAVID LEHMAN, CHIEF AGRICULTURE ECONOMIST, CHICAGO BOARD OF TRADE
    Mr. LEHMAN. Thank you, Mr. Chairman. Good afternoon, members of the subcommittee. I'm pleased to be here today representing the Chicago Board of Trade. As you know, it's the world's leading futures exchange, and we trade futures and options contracts on all of the major grains.
    We also trade futures and options contracts on crop yields. These are relatively new contracts for the states of Iowa, Illinois, Indiana, Nebraska and Ohio for corn. We have wheat yield contracts approved for Kansas and North Dakota, and soybean yields for Illinois.
    We recognize that the implementation of the FAIR Act has given producers greater flexibility to produce for expanding world markets. However, it has also given them more responsibility for risk management.
    The recent soybean market decline following the June 30 acreage report is a good indication of the impact of increased planning flexibility and the resulting price volatility.
    In light of the movement both in the United States and throughout the world to reduce Government subsidies and trade barriers, the CBOT appreciates the need for development of new risk management tools. As you know, the CBOT has been at the forefront of this activity, working with USDA to develop and implement the options pilot program authorized by Congress in the 1990 farm bill as a forerunner of market based marketing strategies, and in designing and launching the crop yield insurance contracts.
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    CBOT is also actively involved in participating with USDA and the Commodities Futures Trading Commission in the Risk Management Education Pilot Program authorized in the FAIR Act. The specifics on CBOT's involvement in that program were detailed to this subcommittee at its April 10 hearing.
    As the leading provider of risk management services for the agricultural industry, the CBOT continues to have strong concerns about lifting the ban on agricultural trade options. These concerns stem from the CBOT's long experience and commitment to assuring comparable regulatory treatment for tradeable risk management products. Generally, the CBOT's concerns fall into broad categories of competitive issues or fair competition and increased risks.
    With regard to the competitive issues, the CFTC's June 9 Federal Register notice, I think, offered a stark description of what agriculture trade options are expected to look like, and I quote: ''Initially, it is expected that agricultural producers and users would enter into put and call options that were very similar to those already offered on-exchange.''
    Simply stated, lifting the trade options ban would give off-exchange products an unfair competitive advantage, since the same heavily regulated options traded on exchanges would be virtually unregulated if traded off-exchange. Therefore, if the ban on trade options is lifted, U.S. futures exchanges should be entitled to a comparable level of reduced regulation as a matter of parity.
    Without a level playing field, the proposed OTC trade options market could develop into a ''shadow market'' with products being offered similar to those developed by organized exchanges and using the advantages of exchange generated price transparency without the disadvantages of the regulatory costs and burdens placed on organized exchanges.
    The CBOT attempted to prepare itself to meet these new agricultural market needs by petitioning the CFTC in 1993 to use its exemptive authority to provide a market for both financial and agricultural products to be traded in an innovative environment with streamlined Federal regulation. However, the CFTC's response was to prevent agricultural products from being included in their part 36 sanctioned pilot program for institutional market because, as the agency stated in its final rules, and I quote:
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    The Commission is of the opinion that these commodities share certain characteristics relating to their underlying cash markets and the seasonality of their production, which make different treatment appropriate***in light of the apparent ability of the currently designated contract markets in these commodities to fulfill the price basing and hedging needs of market users and the untested operation of the Part 36 rules, the Commission believes that caution requires that these commodities be excluded from the pilot program.
    The potential damaging effect which trade options could have on the price discovery process, of which exchange traded futures and options are a vital component, should not be minimized. Accurate and transparent price signals are extremely important indicators used by producers and end users in making production and marketing decisions and formulating business plans.
    Since prices of trade option transactions will not be available to the public, search costs for obtaining reliable market information could also increase. What this means in real terms it that small producers will find it more difficult to determine at any point in time the going market price. Better capitalized institutions will be able to obtain an information advantage which they can translate into better prices for themselves.
    With regard to the increased risks, the CFTC's economists correctly point out in their research, and I quote: ''Trade options bring about a heightened concern about certain types of risk because of differences in regulatory protection and the mechanics of how they are traded as compared to organized futures markets.''
    It's important to note that in the Federal Register notice the Commission's economists took about 6 pages to analyze these risks, while needing only two pages to discuss the benefits. Clearly, we think the risks outweigh the benefits.
    Many people have mentioned hedge-to-arrive contracts, and I would also like to note that I attended the hearings in Memphis and Bloomington that the Commission called, and almost every participant there also mentioned hedge-to-arrive problems.
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    Hedge-to-arrives are off-exchange transactions similar to trade options that don't have any of the built-in self-regulatory safeguards of exchange traded instruments such as price transparency, financial integrity, daily mark to the market and a proven oversight program.
    When hedge-to-arrives created substantial problems in the producer community last year, it also resulted in a black eye for exchange traded products.
    The CBOT recommends several conditions that would need to be included for lifting of the ban on trade options.
    No. 1: Reporting requirements. Both buyers and sellers of trade options should be required to report their positions to CFTC or some responsible self-regulatory body, perhaps a registered futures association or contract market. This information should then be made available to the public in aggregate form similar to the commitments of traders report.
    No. 2: Commercials or other qualified parties should be the only allowed parties to engage in trade options. The size of positions held by commercials should be no bigger than their underlying cash market position.
    The third recommendation is for a pilot program approach. The ban should be lifted slowly using a similar approach as was used to implement exchange traded options. A 3-year program makes sense, and this would allow also a restriction to crop revenue products only, which is a group that is arguing most strongly for the use or the need for more flexible tools.
    In terms of risk management, the final recommendation is that issuers of trade options should be required to hedge their risk by establishing a replicating portfolio of exchange traded futures and options. This cover requirement was previously required by the CFTC as a condition of a no-action granted to a futures commission merchant to issue trade options.
    In summary, lifting the ban on trade options using a pilot approach is consistent with the Commission's earlier approach to allowing exchange-traded options. By restricting it to crop revenue products, it will provide relief where it's most needed.
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    Finally, the CBOT finds it ironic that many of the same groups which have stated strong concerns over the potential adverse impact of the exchange's professional markets proposal on the liquidity and price discovery process of exchange traded instruments are now arguing in favor of lifting the ban on agricultural trade options.
    The CFTC has also been very concerned over the potential impact on the price discovery process of the development of professional agricultural markets which would be allowed to trade on-exchange in a similar regulatory environment as is being proposed for trade options. These seemingly inconsistent views on the effects of professional markets and agriculture trade options on the price discovery process require further explanation.
    Thank you very much, Mr. Chairman.
    [The prepared statement of Mr. Lehman appears at the conclusion of the hearing.]
    Mr. EWING. Thank you, Mr. Lehman.
    Mr. Keith.
STATEMENT OF KENDELL KEITH, PRESIDENT, NATIONAL GRAIN AND FEED ASSOCIATION
    Mr. KEITH. Chairman Ewing, my name is Kendell Keith. I am president of the National Grain and Feed Association.
    The NGFA is recommending that the CFTC lift the ban on agricultural trade options. We urge Congress to support this action by CFTC also.
    We believe there is a strong market need for trade options today, and we think it's imperative that the CFTC act as soon as possible to authorize new tools, at least in time for managing the price and production risk of the 1998 crop. That will be the third crop to be produced under the freedom to farm law.
    There is also a need to give agriculture equal treatment as other industries. If there is a learning curve associated with these tools, we don't think this is any justification for delaying action. Agricultural interests will never be able to properly use tools until they are made available.
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    We also believe that trade options can significantly enhance market efficiency. If authorized, trade options can permit a healthy, competitive environment, both as a complement to crop insurance and as a competitive alternative.
    Some of the benefits of agricultural trade options. They will allow specific tailoring of contracts to meet needs of farmers and commercial marketers. For example, one of the biggest deterrents to farmers forward contracting when price is relatively high is the uncertainty of their production. With the lifting of the ban on trade options, an elevator or processor could, for a premium, permit nondelivery at the farmer's option, thereby permitting more aggressive forward contracting of the crop.
    Trade options can also reduce the risk of some forms of current cash contracting in the marketplace. Some point to the hedge-to-arrive situation of 1996 to demonstrate the dangers of cash market contracting. However, trade options could turn an HTA contract into a less risky tool for marketing, as the trade option or the option to not deliver could be incorporated for a premium into the HTA.
    Let me address also what a trade option is not. There seems to be some confusion about trade options that is causing unnecessary concern. We don't envision these instruments as taking away business from standardized futures and options contracts traded on regulated exchanges. In fact, we see trade option instruments adding to the business of organized exchanges and price discovery.
    Similar to cash contracts, we see trade option contracts likely to be designed in a way that they can easily be replicated for multiple customers and designed so as to permit the risk to be efficiently transferred to a regulated futures exchange. This is exactly what we see today in cash grain contracting.
    Exchanges will enjoy higher volumes because of this, but in the interest of avoiding burdensome regulations, we are recommending against mandated exchange hedging of trade options.
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    On the risk side, yes, there will be risks associated with trade options. However, we don't perceive the risks involved in trade options as being all that much different from the risks associated with traditional cash forward contracts.
    Current cash contracts now in use entail a number of risks of varying degrees, as we pointed out in a 1996 White Paper on this subject. There are futures price risks. There is basis risk, spread risk, implied volatility, yield risk, margin risk, counter-party performance risk, and also legal risk.
    Lifting the agricultural trade options ban would provide buyers and farmer-sellers with new tools to manage, reallocate and even eliminate some of the contract risks.
    We are recommending that the CFTC lift the ban, initially approve trade options as a pilot program, require a notification to CFTC by companies that are planning to write trade options, and require risk disclosure but permit the marketplace—that is, private firms—to determine the appropriate form and content of risk disclosure statements, because we think that the risk involved in certain trade options is definitely higher in the case of certain products that will be offered than in the case of others.
    While we are recommending that CFTC not mandate specific education requirements to use or offer trade options, we do believe it's very important that high quality, voluntary education programs be offered and actively encouraged among a wide variety of agricultural groups and organizations.
    The National Grain and Feed Association is committed to a leadership role in this educational challenge. We encourage Congress, CFTC and USDA to continue to support viable risk management education for producers and others in agriculture.
    Thank you.
    [The prepared statement of Mr. Keith appears at the conclusion of the hearing.]
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    Mr. EWING. Thank you, Mr. Keith.
    Mr. Reed.
STATEMENT OF HAROLD M. REED, GENERAL MANAGER, GRAIN DIVISION, THE ANDERSONS, INC.
    Mr. REED. Thank you, Mr. Chairman. I'm Hal Reed, and I represent The Andersons, Inc. We are an independent regional participant in the agricultural marketplace in Ohio, Michigan, Indiana, and Illinois. We operate grain elevators and fertilizer and agriculture chemical facilities in those four states. We handle approximately 150 million bushels of grain and a million tons of fertilizer annually, but more importantly, we deal with nearly 20,000 producer customers.
    For the record, The Andersons strongly urges the subcommittee and the CFTC to support lifting the ban on agricultural trade options. We believe there is a clear need and opportunity within the agricultural community that can be addressed by using trade options.
    Eliminating the ban would be a positive step toward the development of more effective marketing and risk management tools. The strength of this need and the significance of the potential benefits suggest prompt action to lift the ban.
    Producers of agriculture commodities are in a new era of risk and opportunity due to the changes in the U.S. farm bill. The law provides significantly more flexibility and freedom to farmers in making marketing and management decisions. With the elimination of deficiency payments, this freedom brings a much more challenging environment for pricing and risk management. My farmer customers want and need the flexibility to meet this challenge head-on. Agriculture trade options will help them do that.
    Additionally, we believe that the changes in the global marketplace will bring a period of increasing price volatility. This suggests that there will be an increasing need for more responsive risk management tools. The CFTC's Department of Economic Analysis acknowledged that in the recent White Paper, saying that agriculture ''needs creative and flexible price management instruments.''
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    My customers are much more diverse and sophisticated now than they were when I began 18 years ago at The Andersons. Farmers can no longer afford to be price takers who simply accept cash prices for their commodities for delivery to an elevator.
    Many farmers are now seeking to produce tailored products for specific purposes, and it is vitally important that those producers have the opportunity to access similarly tailored products for risk management.
    As consolidation and sophistication continues in production agriculture, the customers of The Andersons demand increasingly sophisticated services. The remaining participants are seeking every efficiency they can find. This is particularly true now that the dominance of governmental acreage and price management has lessened.
    Effective risk management tools like trade options are crucial to gain these needed efficiencies. The non-agricultural marketplace has found valuable and competitive uses for trade options in many areas. Agricultural participants can find similar benefits through the introduction of products specifically designed for the uniqueness of agriculture.
    It's very difficult for me to explain why, to my customers, they aren't deemed worthy to have such tools available to them.
    USDA seems to agree with me on the issue of need and opportunity available with the legalization of trade options. They've created the Risk Management Agency to focus on concepts and education that assist producers to manage risk in the changing marketplace.
    Some of the insurance concepts that I've heard from them include characteristics of trade options. In fact, it's my belief that the use of trade options in developing crop and revenue insurance instruments will reduce the cost of such programs to the government and to the farmer.
    Some who are opposed to lifting the ban believe that such a move will result in an abandonment of exchange traded contracts. I strongly disagree, and guaranty you that it will increase our exchange traded volume.
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    The relationship between agricultural products and the futures markets is unique. Futures and options are an integral part of pricing structure for these products, and it will only increase use of the regulated futures markets.
    At the very least, commercials who offer trade options will likely utilize the regulated markets to hedge the risks of their trade options, but we strongly urge that in no way this be mandated. I do agree with the assessment of the Mississippi Farm Bureau as they stated that the use of trade options ''may well enhance the use of regulated futures and options as risk transferring products.''
    Opponents further argue that lifting the ban will encourage fraud and misuse. These concerns exist in every market, regulated or not. From what I understand, the CFTC will retain its powers to act against fraudulent activities involved in agriculture trade options under the anti-fraud provisions of the Commodity Exchange Act.
    We do have a few recommended conditions in lifting the ban.
    We suggest that the rules impose minimum net worth requirements for those offering trade options to lessen the concern for any subsequent surveillance.
    We encourage the ban to be lifted under a pilot program. This approach would provide a safety valve mechanism, should there be any of the concerns outlined in the May 1997 CFTC publication be realized. We believe it should be made clear at the outset that the program is intended to be made permanent at the end of that pilot period.
    During the pilot phase, we suggest that vendors should be required to submit a notice of their intent to offer trade options. This notice should not demand any specific description of the contract terms of features, nor should it carry any kind of approval requirements, just a notification.
    Finally, we believe that the marketers of trade options should provide risk disclosure statements to participating customers. Those statements might include mechanisms for dispute resolution, the customer's acknowledgment that the trade option is non-speculative and intended for a business purpose, and that the customer understands and accepts the financial risks.
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    The Andersons and I, personally, appreciate the opportunity to offer our views today We are convinced that lifting the ban on agriculture trade options will prove to be valuable for our farmers and our industry. We also believe that this will be strategically significant to the longer term viability and growth of agriculture and futures markets in the United States.
    Our farmers need the opportunity to compete by securing revenue and managing financial risk, rather than continuing to chase prices.
    Thank you.
    [The prepared statement of Mr. Reed appears at the conclusion of the hearing.]
    Mr. EWING. Thank you.
    Mr. Georgy.
STATEMENT OF PAUL J. GEORGY, PRESIDENT, NATIONAL INTRODUCING BROKERS ASSOCIATION
    Mr. GEORGY. Thank you, Mr. Chairman, for inviting me to share the thoughts and opinions of the National Introducing Brokers Association. I am Paul Georgy, president of Allendale, Inc., a brokerage and research firm located in McHenry, Illinois.
    Allendale is registered as an introducing broker and as a Commodity Trading Advisor with the NFA and CFTC. I currently serve on the Business Conduct Committee at the NFFA and appear here today as President of the National Introducing Brokers Association.
    The national Introducing Brokers Association is opposed to lifting the current ban on agricultural trade options, and cites the following reasons.
    No. 1: Increasing the number and type of flexible contracts available to producers, in reality, may result in decreased flexibility of marketing, because they are so localized. As elevators personalize each contract, the demand for the exchange option will deteriorate, causing severely reduced liquidity.
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    There wills be an overwhelming supply of unique contracts, but the intrinsic value will be greatly diminished. Therefore, the very characteristics which proponents for lifting the ban cite as advantages to agriculture options are distinctly disadvantages.
    Price discovery will also be inhibited, placing the producer at a disadvantage.
    No. 2: Increasing cost of protection for the producer. Proponents tout lifting the ban will reduce cost of providing the producer with a contract that will offer protection. However, the CFTC as well as other economic groups contend that the potential liquidity risk could actually result in a higher cost product to the producer.
    What about increased commission costs? It's our experience that, when off-exchange contracts were recently offered through elevators, our clients entered flexible arrangements that now have producers locked into a long term lawsuit over losses, a much higher cost of protection, a drain on cash flow that farmers should have to pay.
    No. 3: Decreased or no margin requirements will likely result in less regulatory protection for the producer. No margin requirement is certainly a great advantage for the producer, but if these accounts were legalized, why wouldn't most customers close their regulated accounts?
    In fact, you could speculate that hundreds of IBs and CTAs might drop their registration. Why not? No audits, no financial requirements, no regulatory requirements. Unfortunately, unregulated trading and lack of margin requirements helped contribute to the grave losses and social stress experienced in many communities this year.
    According to a poll of agencies conducted by Allendale, cooperative elevators experienced a 42 percent increase in closures or ownership changes last year. The magnitude of losses in 1996 at the cooperative elevator was more than $40 million, four times the amount of loss in 1995.
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    Total unresolved trading losses as a result of HTA activity is estimated at more than $800 million, and is expected to surpass $2 billion by the time the litigation is completed. This represents approximately 4 percent of the total net farm income, and is one of the most dramatic non-weather related losses to the sector.
    No. 4: Independent elevators will be placed at a disadvantage. The most probable immediate results on the farmer/producer will be a concentrating of grain business of which a few elevators will severely impact the competitiveness of local grain bids.
    While some farmers may benefit from these contracts in the short term, the result will be further constriction of this industry. Small elevators will be forced out of business, and entire communities will suffer.
    The National Introducing Brokers Association remains opposed to lifting the current ban on agricultural trade options. As independent business people, we are interested in any improvements in our industry which will result in increased price protection, flexibility and innovation in marketing for producers.
    We offer the following suggestions, which we believe would help achieve these goals, while maintaining adequate risk disclosure and market integrity.
    No. 1: Encourage regulated exchanges to develop and offer new contracts that allow the producer to buy an option which guarantees profit per acre. This should not be too difficult to develop. Simply use the contracts already available and wrap them together into a package at the exchange. The liquidity, the regulatory procedures already exist.
    In fact, we are aware that the exchanges are already formulating these new concepts that might meet the needs of the industry. The system is responding to the needs of the industry. So why change the system? Thus, the best compromise is no compromise, but rather to insist that all new contracts are traded on the exchange.
    No. 2: Creating new requirements for those conducting trade options transactions. These new requirements should include registration, financial requirements, audit requirements, full risk disclosure, and the authority of the CFTC to regulate the transactions.
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    No. 3: Seminars and educational meetings for vendors and farmers.
    No. 4: Develop a pilot program, if they are authorized, with hearings at the end of the period to evaluate the usefulness of these contracts.
    In summary, increasing the protection for the producer, improving price discovery and increasing the stability of our industry is extremely important to the national Introducing Brokers Association. Therefore, we believe the current ban on agricultural trade options should remain in force.
    Thank you for giving me the opportunity to present the position and concerns of the NIBA. As the committee continues work on risk management issues, our organization stands ready to help in any way that you see fit.
    [The prepared statement of Mr. Georgy appears at the conclusion of the hearing.]
    Mr. EWING. Thank you, Mr. Georgy. Next is Nancy Danielson.
STATEMENT OF NANCY DANIELSON, LEGISLATIVE REPRESENTATIVE, NATIONAL FARMERS UNION
    Ms. DANIELSON. Good afternoon. Thank you, Mr. Chairman, Mr. Condit, for the opportunity to testify today, and thank you for the opportunity to bat clean-up.
    For the record, I would like to tell you that our 300,000 members do not come to you asking to have this ban lifted. We do not have specific policy opposing the ban. However, we do have policy in many areas which would be affected by the ban.
    First of all, I'd like to tell you that what some people have called marketplace freedom today our members would call marketplace volatility, and especially if you have heard form any of your dairy producers or any of your soybean producers, you know this as well as anyone.
    So we are very interested in tools which would allow us to manage risk, but the question in front of you today is: Is lifting the ban actually a way to manage risk, or will it create more risk? From what we've seen so far, we are concerned that it would create more risk.
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    We note that lifting the ban may allow tools to be more tailored to the individual hedger's need, and we note that the risk would be limited to the amount of the premium for the options contract.
    We do not agree with some who believe that it might reduce the need for crop insurance. If anything, we think that producers would not choose to buy options instead of crop insurance, although they might choose to use them both together; but ironically, the very flexibility that we could have by lifting the ban is what creates the risk, and it's very difficult to see after the long history of abuse that is detailed in the CFTC White Paper how this risk problem has changed over the years.
    What have we done differently today that somehow takes away the problem of risk? We don't see anything that would be different that would take away that problem.
    We are concerned that non-standard contracts are difficult to regulate and that the lack of price transparency due to decentralized market makes it difficult for the participants to accurately judge the value of the contract.
    Therefore, if the CFTC decided to lift the ban, we would certainly be in favor of a pilot program approach, and we do have several safeguards which we have listed which would be necessary, but please don't take the fact that we have listed safeguards as a position that our policy is calling for lifting the ban, because we are not.
    Necessary safeguards would be oversight by the CFTC or the SEC and, of course, they would need to come back to Congress to provide additional funding for oversight. We believe that any vendors that trade off exchange agriculture options would have to be periodically audited.
    We agree that disclosure of risk must accompany every contract and should be written in terms that could be understood by the average person. I'm sure we've all seen forms that, from the legal standpoint, maybe give all the protection in the world, but to the person reading them, they tell them nothing.
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    Vendors would need to be bonded at a sufficient level, and in fact, should only be able to do business up to a certain percentage of their bonding; and of course, education would be extremely important.
    What my members point out to me is that, until there is more understanding in this area, they would be very unlikely to participate in such contracts.
    I was very interested in a statement provided by Bill Biedermann of Allendale, Inc., and some of the same points were made by his partner, Paul Georgy, today. They point out flaws which would be very important to our members.
    First of all, they talk about the fact that allowing these contracts might put the smaller elevators at a disadvantage, and you would actually create more vertical integration in the industry.
    This has been a very large concern to our members. We look at what's happening with vertical integration today. We see everything is moving in that trend, and to do one more measure that would increase vertical integration is definitely a step in the wrong direction.
    We also note that today in the cattle industry we have a problem with formula pricing, and the problem with the formula pricing is that the supply is locked in ahead of time. The contract is made, and they say, ''OK, you agree to provide X number of cattle on X day in the future, and you can have it for whatever the price is that day, the market price.''
    It sounds fair until you look at the fact that that removes all the demand, and all of a sudden the market price on that day turns out to be very flat, and the producer loses a lot of money. It seems that a similar situation can occur with this where the grain supplies would be locked in ahead of time, and all of a sudden, the market price becomes very flat, and again the producer is the one who suffers.
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    Also the fact that accounts that are now regulated may in the future become unregulated as they are competing with other unregulated accounts. So again we are going in the wrong direction.
    I guess the last thing I would mention is that, as many of the other witnesses today, we still have the case of the HTAs fresh in our mind, and we can't afford another $2 billion fiasco. So until we have something to ensure that we can have appropriate oversight and that we would not have the problems of fraud and abuse which have existed in past option trading, we would be against lifting this ban.
    Thank you for the opportunity to testify.
    [The prepared statement of Ms. Danielson appears at the conclusion of the hearing.]
    Mr. EWING. Thank you to everyone on the panel. I think lifting the ban just was approved 4 to 3 by the members of the panel, if that carries any weight.
    I do have a few questions. Several mentioned that, if the ban were lifted, they would like to see a pilot program for agriculture trade options. How extensive do any of you who mentioned that believe such a pilot program should be, and in what areas? Mr. Lehman?
    Mr. LEHMAN. Well, Mr. Chairman, as I mentioned, we were involved in, as I'm sure you know, the development of the Options Pilot Program in the 1990 farm bill, which we believe was really a forerunner to what then occurred in the 1996 farm bill of really removing the price support and income subsidy programs with a recognition that the exchanges offer the tools that are needed, and producers can use those to manage their risk.
    That program was a very small program. It was restricted to 7 counties initially, and it was expanded eventually to 21 counties. It was kept very small so that it could be monitored, and so that it could be very controlled and result in an adequate test.
    In terms of length, while it was authorized in the 1990 farm bill, it took about 2 years to put it together with USDA. So that's something that needs to be considered. It takes a while to design it. It then was implemented for 3 years.
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    So those are some of the parameters that I would recommend.
    Mr. EWING. Anybody else? Yes, Mr. Keith.
    Mr. KEITH. Our association would favor a pilot that really had no limits on geography, but rather was offered in a way that CFTC actively monitored that pilot, watched what was going on; but we see this as something driven by the private marketplace, typically with new products being driven only by the private marketplace and not by government.
    It grows slowly, and we would anticipate that we would see the same phenomena here as being something that the CFTC could monitor during a pilot phase.
    Mr. EWING. Yes, sir, Mr. Georgy.
    Mr. GEORGY. Mr. Chairman, if a pilot program was put into effect, I think some part of the market activity is going to be extremely important, and that is you need to have a pilot program during a bull market, which this year HTAs would never have been a problem if we would have had a down market.
    Some of the options selling programs that elevators had suggested to their customers to get into and selling calls at 2 to 3 times their production would never have happened if the markets would have been down, and the pilot program and these option strategies would have been extremely successful.
    That's the thing about a pilot program. It's got to stretch over a period of time where market volatility exists, where price movement goes to extremes, like we had in 1996.
    Mr. CONDIT. Mr. Chairman, would you yield on that?
    Mr. EWING. Yes, I certainly will.
    Mr. CONDIT. What is the period of time where you get a good measurement of the market?
    Mr. GEORGY. If we knew that, we would all be wealthier, I suppose, but I think the trend seems to be every 5-year period there's a spike in prices in agricultural commodities, corn and soybeans. I mean, if you look at a historical chart, you've got on the monthly chart tracking the corn and soybeans over a 5-year period, there usually is some type of a spike for some reason or other.
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    Mr. EWING. Well, we had pretty much a decade of level prices in the late eighties and early nineties, if my memory is correct.
    To those of you who are in favor of this, most of our grain operators or grain elevators are regulated, have to meet standards, have to prove their financial responsibility and liquidity. At least, they are in the state of Illinois. I think most of that is probably state regulation.
    Is there a fear of unscrupulous or unethical trading that could take place, you know, different at every elevator and different commodities or different contracts being offered?
    Yes, sir, Mr. Whisenhunt.
    Mr. WHISENHUNT. There has always been that, Mr. Chairman. I suppose maybe I'm one of the few producers that's on the panel at this time, and I speak not just for the organization but as a producer.
    This has been one of the risks that we've had through the years, is you have to have some feeling of integrity and honesty and that the person knows what they are doing when you deal with someone; and we have that. We always have when I've dealt with brokers.
     I've dealt outside of that with just forward contracting with organizations. In the State of Arkansas we have some co-ops that have been very—in the marketing of our product, in rice, in soybeans and wheat, sorghum and in the region with cotton co-ops.
    We have built through those co-ops a feeling that these people are—they have integrity, that they want to work with us and for us, and it's an opportunity for that young or that small producer using these facilities and with this added that that would not be the feeling that so many times we hear in other places; but there is that underlying always.
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    Mr. EWING. In your testimony you talked about walk-away contracts. How do you define a walk-away contract?
    Mr. WHISENHUNT. If the conditions were met and there was no liability at the end of it, that you would simply be able to walk away without any penalty at that point.
    Mr. EWING. I see. Mr. Sandner, did you have a comment?
    Mr. SANDNER. I'm not for a pilot program and, but I wanted to make a comment why, and it bridges right into the integrity issue.
    Certainly, there is a tremendous integrity in the farm community, but history, as I said, is replete with all sorts of frauds and abuses. I think everybody is trying to find value in these trade options over-the-counter, and perhaps there is some value, and the challenge for the exchanges to try to give the same kind of value.
    Notwithstanding that, the real key issue—and we can sit here and talk about pilot programs and pricing, and it's got to be in a bull market—but the real issue is how everybody wants to monitor this, virtually, under the CFTC. So it's off-exchange, but it's regulated by the CFTC.
    I think the first question that has to be addressed is how in the heck can the CFTC truly monitor and regulate when everybody wants risk disclosure, so everybody understands what the risk is of doing one of these contracts, like they have on the exchanges. They want audit trail. They want audits, continual audits of everybody.
    Every single thing that we have in our marketplace, they would like to know the financial safeguards are there, all the things that the CFTC does with us, which is very—it's not easy, but it's manageable, because they're in a centralized marketplace with a tremendous amount of experience in record keeping.
    If you took that structure and you made it fragmented where there was no centralized way to go and collect the data and to do all of these things, it will be an impossible task to monitor.
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    So everybody is saying there might be some value in these kinds of things, so let's look at a pilot. But a pilot wouldn't even be realistic because ultimately when you open up Pandora's box, there would be no way for them to engage in a serious, conscientious audit for financial safeguards, disclosures, pricing, and all the things that are at least manageable in a centralized marketplace that wouldn't be there.
    So notwithstanding some value that someone might be arguing would be created by a trade option produce off-exchange that maybe isn't on the exchange, that value, which I would at some other time like to debate—that extra value added, compared to the monitoring and the compliance and all the things that everybody seems to want in place—and why do they want them in place? Because they don't want fraud. They don't want the abuse, and all the things that have happened when these things aren't in place, and they're virtually impossible for a regulatory agency to put in place in any reasonable way.
    Mr. EWING. Mr. Sandner, if you didn't have to provide all of those safeguards, could you offer a contract at a lower cost? Is that what we're talking about here?
    If you're going to have these contracts lift the ban—and I understand it could be competition to the organized exchanges, but you would be providing very different services, a lot more security and, certainly, over here with something maybe less certain, less secure.
    Is that part of the issue here?
    Mr. SANDNER. Well, theoretically, in some kind of an economic model, if you have less regulation and encumbrances, basically, on staff and things that you have to do, you could provide it at a lesser cost.
    The problem is, when you start to provide things at a lesser cost, the reason you're doing it is because you're competitively driven to do it. You're not just doing it, because you're an altruistic organization. You're doing it, because you're competitively driven to do it.
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    The reason you're competitively driven to do it is because there's other people competing with you in a centralized marketplace. So everybody knows what everyone is doing. So my commission is 8 bucks. Well, another firm is going to charge $7.50.
    In a decentralized marketplace there isn't this kind of competition that is able to be visible and discernible to cause you to do the pricing on a competitive basis. So my opinion is that prices would go higher.
    I can remember when they did options on gold bullion and the things that they did a number of years ago. They were charging two-thirds of the premium for a commission, which was outrageous. You couldn't possibly make any money when they charged that kind of commission.
    The reason they did it is greed took over. Nobody really had a competitive pricing model for commissions. They charged whatever the market would bear, and the market was this individual being talked to on a phone, and they charged him this kind of commission.
    So I think the price would go up astronomically, because there wouldn't be a competitive model that would be visible, that one could draw from to create a pricing that would be a lower cost.
    Mr. EWING. So, Mr. Sandner, it doesn't necessarily go along that less services, less regulations, less safety will get a cheaper price for the producer?
    Mr. SANDNER. No, it does not, because it's not centralized and competitive.
    Mr. EWING. Mr. Reed, I believe you mentioned you didn't want an education program. Is that right?
    Mr. REED. No, I did not mention education requirements.
    Mr. EWING. Did one of you? Was it you, Mr. Keith then?
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    Mr. KEITH. I did, yes, not a mandated program. Yes.
    Mr. EWING. Could you give us a little more insight into that?
    Mr. KEITH. I guess part of our belief is that regulations aren't the answer to everything. We think the goal really of all interested groups, producers, agribusiness, CFTC, USDA, should all be the same, that we should go out and try to develop high quality education programs on risk management tools, be they trade options, options on exchange, regular futures contracts, crop insurance, the whole gamut.
    We all need to become better marketers, better risk managers, but we don't think regulations forcing people into seminars or classes and so forth is the answer. We think you have a much better chance of success if people go voluntarily, wanting to learn, and getting strong encouragement from USDA, and agencies like CFTC.
    Risk disclosure can help in some of this, in some cases. We envision that some firms might want customers to sign risk disclosure statements that they do understand these things and, in fact, it may spur people to want to become better educated.
    Mr. EWING. Well, I think there is a difference between regulation and education, but your comment was mandated, formalized education which would be more a part of the regulations than just good informational offered by the elevator or whoever might be promoting their product?
    Mr. KEITH. We envision education as being much broader than people that are promoting a product. We see it as having agencies involved, having regulators involved, to present a balanced viewpoint of these products as to what they can and can't do.
    We see exchange base products as having certain advantages. Certainly, the guaranty the clearing corporation provides on performance is an outstanding advantage, and that should be marketed. That should be told far and wide.
    Trade options allow things that we see exchange instruments not being able to do. I mean, it allows risk management on quality factors. It allows risk management on basis in the marketplace. It provides for risk management in arenas that exchange based products do not offer today.
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    Mr. EWING. Is there anyone else on the panel that would have a closing comment that they would like to make? Mr. Whisenhunt.
    Mr. WHISENHUNT. I'd like to follow up just a little bit on the question concerning education. I remember when options first became available to farmers in Arkansas, and our organization put on seminars, and we continued to put on marketing seminars for the purpose of educating.
    We don't want it mandated. Certainly, a farmer can go to college. He can get a college education on how to farm, but we don't say he has to before he can buy a farm and operate it; but he will do a much better job most of the time.
    What we want to see is an opportunity for that small farmer, working through his co-op or his bank or whatever the institution might be where he has confidence, to be able to use this tool. You talk about risk management. We're not trying to increase the risk. The risk is already there every day of the week and every month of the year.
    We want to know how do we turn this risk into something that we can control and manage. This is a way we do it. We're not going to be encouraging our people to listen to every phone call from somebody that says I know how to make you money in agriculture options that he doesn't know. That's one of our problems now, is we don't have enough people that's close enough at home who we have confidence in that will help us in our marketing.
    This is a way that we can do it. Our big operators use the brokerage firms. They know them, and they talk to them every day. We're not worried about those. It's these small farmers that don't know how, and we have to have a link, and this is a way that we can provide it.
    Thank you, sir.
    Mr. EWING. Yes, Mr. Reed?
    Mr. REED. Just a quick comment. There are very few producers today who use the futures and options market for a wide variety of reasons, but those same people will forward contract cash grain for large sums of money on deposit with local elevators for fertilizer and chemicals and seed, because of the trust factor and the relationship factor that they have with many of those people.
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    Now for us to make available to them the risk management tools in the size and increments and tailored variety that they want and they need on a smaller spectrum for people who will not open up a futures or options account is not taking business away from anyone.
    The notion that it could be more expensive for them is kind of interesting, because they're not using the tools today. So what's more expensive, not using the tools or having some price mechanism?
    Their notion that they can't tell whether or not they are being gouged for a product or a service is kind of a little bit demeaning to the farmer customer who is trying to buy that product or that service or that insurance and marketing his grain.
    So I think that our ability to get those risk management tools to that group of people who don't use the futures and options market directly today serves a great interest in the farm community in risk management and helps promote better price discovery and liquidity in those markets from the people who will use them to hedge those products on the regulated exchanges.
    Mr. EWING. Anyone else? Yes, Nancy.
    Ms. DANIELSON. In preparing for the testimony today, I discussed it with our Illinois State president, Larry Quandt, whom you may know. One of the examples that he talked about was the price later contracts that are used in his state and that, under those contracts, ownership of the grain conveys on delivery, not on payment.
    A lot of times, even though the producers sign the statements ahead of time, they really don't find out until there is some type of problem with the elevator that suddenly, although they haven't yet been paid for their grain, they no longer own it. Luckily, in your state they are protected up to 80 percent because of the grain insurance fund, but in a lot of States they don't have that.
    Our Iowa president lives right near Stockport, IA, where they had three major grain elevator failures, and they no longer have any kind of fund to protect producers in their state.
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    I think it's an example of sometimes producers get into something, and maybe they don't quite understand how it works, or they don't really understand the full regulations of it until after it's too late. If we move in this direction of allowing more off-exchange traded options, we have to be sure that we do have the education there, but also that we have the protections in place, because if we just go ahead and allow it, people think it's okay to use it, and they find out later it really wasn't okay.
    Mr. EWING. Yes, Mr. Georgy?
    Mr. GEORGY. Yes, Mr. Chairman. We talked about the size of the farming operations, and the size of the farms become larger and larger every year as older farmers retire and sons and so forth take over.
    The size of contracts at the Board of Trade are 5,000 bushel, in the Mid-Am are 1,000 bushel. So we do have tools that they can take advantage of right now, if they so desire to do that.
    A concern that we have is even with putting the price risk aside, there's a basis risk that the producer has to be aware of. It's our concern, if he makes—and the elevator takes enough contracts, options, to price out, let's say, 3 to 6 months, when it comes time at that time for somebody who did not price the grain ahead 3 to 6 months, the basis may stay very stable, as Ms. Danielson had suggested in the livestock that we've got a problem with.
    It could mean up to 20 percent of the value of the grain, just in the basis fluctuations. So he may be losing a lot of potential profit in the fluctuation of the basis that he missed out on because of these contracts.
    Mr. EWING. Yes, Mr. Sandner?
    Mr. SANDNER. A closing comment, Mr. Chairman. When I hear that people are able to take care of themselves, that the banks want to be able to offer these kinds of things, and that fraud wouldn't be apparent out there, I'm really amazed; because all these bans were created because it was rife with fraud and rife with manipulation.
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    This isn't a case of first impression, and we're opining out of history and a record. I mean, that's why all these things were banned, because it was rife with fraud, rife with abuses. So what has changed, as Nancy testified to, that says that this won't occur?
    So I can hear people suggest this just won't occur. Well, that's dreamland. It will occur. So let's give it to everyone, but let's make sure it doesn't occur, and we'll set up all these rules and regulations, and I keep hearing, well, they got to be educated.
    What they're saying is that, not only do they have to be educated, but they got to understand the risk, if they're educated. Well, how are we going to know if they're going to do that? The way the CFTC does it now is they require lengthy risk disclosure, and over the years it was even much more extensive for options than it was for futures. You had two different risk disclosures, one for options and one for futures.
     When we do these risk disclosures, it isn't just saying we've done them. Now who is going to check that they're doing? Right now, there's a deep structure to check that they're done. The CFTC can come into your offices and check every risk disclosure to make sure it's done.
    They can tell the exchange who has an extensive staff, which would not be in place for this, to check and make sure that all the risk disclosures are there, and then to verify that and affirm that to the CFTC. The CFTC then comes and checks at the exchange.
    The NFA, the self-regulatory agency, has an entire staff around the country that does exactly the same thing for risk disclosures and all these things. So there's a deep structure to monitor all this. Why? Because it isn't just saying that let's have a risk disclosure. It's finding out whether the risk disclosure was executed properly and people understand it.
    That's just one of many, many things in the regulatory profile for protections to make sure there aren't these kinds of abuses. Well, who's going to do all of that? There's no exchange to help. There's no NFA to help, and all you have is the CFTC, and they've got a lot on their plates. So how are they going to do it in a decentralized, fragmented marketplace?
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    So we can talk about there's integrity out there. We can talk about that they want to be able to do this with their banks, because they have these relationships. Well, then why were they banned in 1936, and why, every time they've been revisited and when there were some non-enumerated products allowed to trade options, it was rife with fraud, because that's where things gravitate to if there isn't a proper monitoring of it and regulations to make sure that people understand what's going on; and it won't happen here.
    Mr. EWING. I want to thank both panels and, thank you, Chairperson Born, for sitting through the second panel—I think you found it as interesting as I have—and to my ranking member, Mr. Condit, for his participation.
    It is not in the script, but we were lucky to get through with no votes. That always makes a good hearing, and for some reason today, because it is so cold in here, the Red Cross will be serving coffee and doughnuts outside.
    Thank you all very much. If there are no further questions, I would thank all the witnesses. The record will remain open for 10 days to accept statements and any additional information, and the subcommittee is adjourned.
    [Whereupon, at 4:17 p.m., the subcommittee was adjourned, subject to the call of the Chair.]
    [Material submitted for inclusion in the record follows:]
TESTIMONY OF BROOKSLEY BORN, CHAIRPERSON, COMMODITY FUTURES TRADING COMMISSION
    Mr. Chairman and members of the subcommittee, thank you for providing the Commodity Futures Trading Commission with the opportunity to discuss agricultural trade options before the subcommittee today. I am confident that today's hearing will have a dual benefit: informing the Subcommittee about an issue important to the agricultural community and assisting the Commission in its current consideration of whether to lift the ban on agricultural trade options. Accompanying me are Commissioners John E. Tull, Jr., Barbara Pedersen Holum, and David D. Spears.
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    My testimony on behalf of the Commission will focus on three areas: a history of options on agricultural commodities; a discussion of the Commission's staff White Paper on agricultural trade options; and a description of the Commission's process for reviewing whether to lift the ban on agricultural trade options.
    Options are transactions that grant one party the right, but not the obligation, to buy or to sell a commodity or other interest at a certain price. Options trading can be broken down into two broad categories—exchange-traded options and off-exchange options. Trade options are off-exchange commodity options which can be offered only to a commercial person or entity solely for purposes related to that person's business. Trade options are currently prohibited on certain agricultural commodities listed in the Commodity Exchange Act, although permitted on other commodities.
    If agricultural trade options were permitted, a corn farmer could purchase an option from an elevator to sell the farm's anticipated production of corn at a certain price. Similarly, a wheat miller could buy an option to purchase wheat from a grain dealer for processing at a certain price.
    Agricultural options—both on- and off-exchange—were traded in the United States at least from the time of the Civil War until the 1930s. However, concerns about fraudulent sales practices, failures to perform on over-the-counter obligations, and the use of exchange-traded options to manipulate the prices of agricultural commodities prompted numerous industry and government efforts to limit or to eliminate trading in agricultural options. In 1936 Congress banned all sales of options on certain agricultural commodities listed in the Commodity Exchange Act. Today, those listed commodities include the major grains, oilseeds, cotton and livestock products, among others.
    Congress's ban did not apply to all commodities, and fraud and abuse in options markets in non-listed commodities, such as gold, was one of the reasons for creating the Commodity Futures Trading Commission in 1974. The 1974 amendments to the Commodity Exchange Act vested the Commission with broad-based authority over both on-exchange and over-the-counter options markets in non-listed commodities, but left in place the 1936 ban on options in the listed commodities. Shortly after its creation, the Commission adopted rules that exempted over-the-counter trade options in non-listed commodities from most regulatory requirements. However, the Commission retained the power to enforce fraud and manipulation prohibitions as to such trade option transactions.
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    Despite historical problems associated with commodity options, there remained considerable commercial interest in their use. Accordingly, in 1981 the Commission instituted a pilot program for exchange trading of commodity options in commodities other than the listed agricultural commodities. In 1982 Congress lifted the 1936 statutory ban, allowing the Commission to permit options in the listed agricultural commodities. The Commission permitted exchange trading in these agricultural options in 1984. However, the regulatory ban on agricultural trade options was maintained.
    The reintroduction of exchange-traded commodity options has been a commercial and regulatory success. Neither they nor trade options on the non-listed commodities have posed unusual regulatory problems.
    Although the Commission has considered lifting the regulatory ban on agricultural trade options several times over the last 15 years, the Commission has not acted to reintroduce trade options on the listed agricultural commodities, choosing instead to leave the ban in place. There have been deep divisions within the agricultural community on the issue. Opponents of lifting the ban have expressed concerns over possible fraudulent activity and suggested that such contracts might result in confusion in the producer community, particularly regarding the delivery obligations. Nonetheless, there also have been repeated calls throughout the years for the Commission to permit broader use of trade options in the agricultural sector.
    Earlier this year the Commission asked its Division of Economic Analysis to prepare an analysis of the issues surrounding agricultural trade options. The Commission's request in part reflected increased producer interest in additional risk management tools in light of the significant changes in U.S. farm policies enacted in the 1996 Federal Agricultural Improvement and Reform (FAIR) Act. In May 1997, the Division's staff completed a White Paper entitled ''Policy Alternatives Relating to Agricultural Trade Options and Other Agricultural Risk-Shifting Contracts,'' a copy of which is attached to our testimony.
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    The White Paper analyzes the current regulatory environment, recent developments in agriculture that have expanded the need for risk-shifting strategies, the benefits and risks of agricultural trade options, and possible ways to strike a balance between such benefits and risks. Based on this analysis, the White Paper concludes with a series of staff recommendations for the Commission to consider.
    A central benefit identified in the White Paper is that lifting the ban on agricultural trade options potentially would provide producers and end-users with a greater variety of risk-management tools. Other benefits derive from customization to meet particular needs. Customized options would permit more precise matching of hedges to amount, timing, quality, and other commodity characteristics. The White Paper additionally cites benefits from increased competition, such as the potential increase of the supply and variety of agricultural options and possible lower costs to users.
    The White Paper also describes various risks associated with trade options. Six risks are highlighted in the white paper: fraud, credit risk, liquidity risk, operational risk, systemic risk, and legal risk.
    The White Paper suggests that the Commission should consider whether to lift the ban subject to appropriate regulatory conditions. Three categories of conditions are discussed in the White Paper: (1) restrictions on eligibility of the parties; (2) restrictions on the instruments and their use; and (3) regulations on the marketing of the instruments.
    Based on the White Paper, the Commission decided to seek public comment on whether the Commission should lift the ban and, if so, what regulatory conditions would be appropriate. A Federal Register notice dated June 9, 1997, requested interested persons to address a number of specific questions that would assist the Commission in its deliberations on whether to issue a proposed rule to lift the ban on agricultural trade options. A copy of the Federal Register notice is attached to our testimony. Written comments are due to the Commission by July 24, 1997.
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    The Commission has just completed two field meetings on the subject. All five of the Commissioners attended the meetings in Bloomington, Illinois, and in Memphis, Tennessee. The statements by interested persons at the meetings were very thoughtful and informative. After analyzing and considering all public comments, the Commission will determine whether to propose a rule lifting the ban on agricultural trade options. If it were to decide to do so, the proposed rule would be published, and public comment on the proposal would be solicited and considered prior to any decision whether to adopt a final rule.
    The Commission is committed to considering this important issue carefully in light of the history of options trading, the increasing need for price risk management by agricultural producers, the views of all interested persons and a thoughtful weighing of risks and benefits. Thank you again for the opportunity to appear before you today. The Commission looks forward to working with the Subcommittee on agricultural trade options and other matters.
STATEMENT OF DAVID LEHMAN, GROUP MANAGER OF COMMODITY PRODUCTS AT THE CHICAGO BOARD OF TRADE
    Good afternoon Mr. Chairman and members of the subcommittee. I am David Lehman, Group Manager of Commodity Products at the Chicago Board of Trade (CBOT), and I am pleased to be here today representing the Chicago Board of Trade.
    The CBOT is the world's leading futures exchange, trading over 224 million contracts in 1996, covering a broad range of agricultural products and financial instruments. The CBOT's agricultural contracts include futures and options on prices for corn, wheat, soybeans, soybean meal, soybean oil, oats and rice. In addition, the CBOT offers the only futures and options contracts on state level yields for corn for the States of Iowa, Illinois, Indiana, Nebraska and Ohio; and is approved to trade wheat yield contracts for the States of Kansas and North Dakota and soybean yields for Illinois.
    Implementation of the new commodity programs contained in the 1996 Federal Agricultural Improvement and Reform Act has given U.S. producers greater flexibility to produce for expanding world markets; however, that change has also required that producers assume more responsibility for risk management. Elimination of annual acreage reduction programs and the target price and deficiency payment programs requires producers to develop market-based risk management strategies. The recent soybean market decline following USDA's planted acreage report on June 30 underscored the market impact of producers' increased planting flexibility and the resulting price volatility.
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    In light of the movement both in the U.S. and throughout the world to reduce government subsidies and trade barriers in commodity markets, the CBOT appreciates the need for development of new risk management tools and hedging strategies for producers and end-users. As you know, the CBOT has been at the forefront of this effort, working cooperatively with the U.S. Department of Agriculture (USDA) to develop and implement the Options Pilot Program authorized by Congress in the 1990 Farm Bill as a forerunner of market-based marketing strategies and in designing and launching crop yield insurance futures and options contracts. The CBOT is also actively participating with USDA and the Commodity Futures Trading Commission (CFTC) in the implementation of the Risk Management Education Pilot Program authorized in the 1996 FAIR Act and continues to commit a significant portion of its education and marketing resources to agricultural risk management. Specifics on the CBOT's involvement in that program were detailed to this Subcommittee in an April 10 hearing.
    As the leading provider of risk management services for the agricultural industry, the CBOT continues to have strong concerns about lifting the ban on agricultural trade options. These concerns stem from the CBOT's long experience and commitment to assuring comparable regulatory treatment for tradeable risk management products. Generally, the CBOT's concerns fall into two broad categories: fair competition and increased risks of fraud and counter party default.
    Competitive Issues. The CFTC's June 9, 1997 Federal Register notice offers a stark description of what agricultural trade options are expected to look like and explain our competitive concerns. The CFTC says: ''Initially, it is expected that agricultural producers and users would enter into put and call options that were very similar to those already offered on-exchange. ''
    Simply stated, lifting the trade options ban would give off-exchange products an unfair competitive advantage, since the same heavily-regulated options traded on exchanges would be virtually unregulated if traded off-exchange. Therefore, if the ban on trade options is lifted, U.S. futures exchanges should be entitled to a comparable reduced level of regulation as a matter of parity. Without a level playing field, the proposed OTC trade options market could develop into a ''shadow market'', with products being offered similar to those developed by organized exchanges and using the advantages of exchange generated price transparency without the disadvantages of the regulatory costs and burdens placed on organized exchanges.
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    In the Advanced Notice of Proposed Rulemaking concerning the possible lifting of the statutory ban on agricultural trade options, the CFTC's Division of Economic Analysis listed as one of the possible benefits of agricultural trade options ...the potential for a greater supply of, and competition in offering, option contracts.... The CBOT is a strong proponent of open and competitive markets—free markets and competition are the essence of exchange-traded futures and options markets. However, allowing off-exchange options to trade without the regulatory costs imposed on exchanges would place exchange-traded products at a severe competitive disadvantage. In this situation, given the relatively less costly trading environment available off-exchange, market participants will logically choose to trade in the less expensive, over-the-counter market, resulting in a loss of liquidity and a less efficient price discovery process for the exchange agricultural markets.
    The CBOT attempted to prepare itself to meet these new agricultural market needs by petitioning the CFTC in 1993 to use its exemptive authority to provide a market for both financial and agricultural products to be traded in an innovative environment with streamlined Federal regulation. However, the CFTC's response was to prevent agricultural products from being included in their Part 36-sanctioned pilot program for institutional markets, because, as the agency stated in the final rules (Federal Register, October 2, 1995): ''The Commission is of the opinion that these commodities share certain characteristics relating to their underlying cash markets and the seasonality of their production, which make different treatment appropriate...In light of the apparent ability of the currently designated contract markets in these commodities to fulfill the price basing and hedging needs of market users and the untested operation of the Part 36 rules, the Commission believes that caution requires that these commodities be excluded from the pilot program.''
    The potential damaging affect which trade options could have on the price discovery process, of which exchange-traded futures and options are a vital component, should not be minimized. Accurate and transparent price signals are extremely important indicators used by producers and end users of commodities in making production and marketing decisions and formulating business plans. Since prices of trade option transactions will not be available to the public, search costs for obtaining reliable market information could also increase. What this means in real terms is that small producers will find it more difficult to determine, at any point in time, the going market price. Better-capitalized institutions will be able to obtain an information advantage which they can translate into better prices for themselves.
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    An additional competitive concern of the CBOT is the ability of the over-the-counter industry to develop and market innovative products in a comparatively unfettered manner. It has been said that the recent increase in the use of over-the-counter cash-market instruments has been a reaction to the changing needs of the end-users. Specifically, the end-users appear to want a wider and more flexible array of marketing tools. Because the over-the-counter industry is free from regulation, it is relatively easy for the over-the-counter industry to develop and market creative new products that quickly respond to changing needs of end-users. The CBOT, on the other hand, is required to engage in a lengthy and costly regulatory approval process prior to trading any new product. Thus, as a matter of fairness, if the ban on trade options is lifted, the CBOT would seek and expect to receive identical relief in the form of trade option status for our exchange-traded markets.
    Increased Risks. The second area of concern raised by the CFTC's proposal to allow agricultural trade options is that these instruments may actually increase risk in the marketplace rather than reduce it. The CFTC's economists correctly point out in their white paper on agricultural trade options, ''trade options bring about a heightened concern about certain types of risk because of differences in regulatory protection and the mechanics of how they are traded as compared to organized futures markets.''
    The increased risks identified in the CFTC's Federal Register notice are fraud risk, credit risk, liquidity risk, operational risk, systemic risk and legal risk.
    All OTC options embody counter party credit risk (risk of counter party default) and, because these are unreported private transactions, lack price transparency. The reality of this risk and its potential repercussions for exchange-traded products became painfully evident in the hedge-to-arrive (HTA) debacle. Since HTAs are off-exchange transactions similar to trade options, they did not have any of the built-in self-regulatory safeguards of exchange-traded instruments such as price transparency, the financial integrity of a strict clearing system with daily margining and mark-to-market realism, and a proven oversight program conducted by qualified market surveillance staff. In addition, many market participants and others thought that HTAs were exchange-traded instruments because they were tied to publicly-available exchange prices. When HTAs created substantial problems in the producer community last year, it also resulted in a black eye for exchange-traded products.
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    Increased fraud risk is primarily due to the lack of regulatory oversight and is the primary reason why trade options have been banned. The greater potential for fraud and abuse in the decentralized over the counter market, compared to centralized exchange markets, was clearly noted in the CFTC's Advanced Notice of Proposed Rulemaking, requiring a lengthy two-page description. The CFTC observed that without traditional market surveillance tools it would be more difficult for fraud to be detected and would create an environment conducive to fraudulent practices. The CFTC even questioned its own ability to enforce anti-fraud protections on the national level if the ban is lifted.
    Liquidity risk is caused by highly customized contracts that could be impossible to liquidate should marketing needs change. The greater liquidity risk associated with trade options will likely be manifested to users in higher costs to hedge with these products relative to exchange-traded products. Operational risk refers to the ability of a counter party to monitor and control its operations in order to assess how the contract interacts with other areas of the business at any particular time and to quickly respond to changes in the marketplace. This may prove very difficult when trade options with complex, imbedded or exotic structures are involved.
    Systemic risk refers to the possibility of a widespread economic disruption caused by a large OTC instrument default. Default would certainly have a negative and possibly catastrophic effect on local economies that are heavily dependent on agribusiness and, if large enough, could create a cascade disturbance throughout the general economy while adversely and unfairly affecting trade in regulated exchange-traded agricultural markets. Finally, trade options could create legal risk of violating Federal or state regulations as in some cases they may constitute illegal off-exchange futures contracts.
    CBOT Recommendations. The risks resulting from lifting the ban on trade options are significant, suggesting a go-slow approach and the specification of appropriate regulatory safeguards. Therefore, the CBOT recommends that the trade option ban be lifted only if the following safeguards are specified to limit those risks:
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    1. Reporting Requirements - Both buyers and sellers of trade options should be required to report their positions to the CFTC or some responsible self-regulatory body, perhaps a registered futures association or a contract market. This information should then be made available to the public in aggregate form similar to the commitments of traders report for exchange-traded markets. While there will be not be a non-commercial category of trade option positions, at a minimum, the total open interest in these transactions should be reported.
    2. Commercials/ Other Qualified Parties - Participation in trade option markets by both buyers and sellers should be limited to commercials and other qualified parties, such as banks and insurance companies. For commercials, the size of allowable option positions should be no larger than the size of positions held in the corresponding cash market.
    3. Registration/licensing - Require that issuers and parties that offer trade options demonstrate their qualifications through licensing and registration requirements similar to those required in the futures industry.
    4. Pilot Program - Lift the ban slowly using a similar pilot program approach as was employed when the ban on exchange-traded options was lifted in 1982. To implement this approach, we recommend that trade options should be restricted during the first three years to crop revenue products only. This would allow the use of these products by producers and grain elevators, which is the market sector that has argued most vociferously for additional flexibility in the risk management tools available.

5.Risk Management - Require issuers of trade options to hedge their risk by establishing a replicating portfolio consisting of exchange-traded futures and options. This cover requirement was previously required by the CFTC as a condition of a no-action exemption granted to a futures commission merchant to issue trade options. This requirement would enable exchanges to provide additional financial security, indirectly, to the trade option market. In addition, this requirement would foster greater risk assessment and financial integrity capabilities for both exchange and OTC markets.
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    Summary. Lifting the ban on agricultural trade options using a pilot program approach is consistent with the approach utilized by the Commission in lifting the ban on exchange-traded options in the early 1980's. A pilot program approach in combination with the recommended regulatory safeguards would also help minimize potential systemic risk associated with lifting the ban on agricultural trade options. Restricting the instruments allowed for the first three years to crop revenue products only will provide relief to the market segment which has greatest need for additional flexible risk management tools. This approach would also provide valuable information to USDA and Congress on the potential for reducing government subsidies for the crop insurance and crop revenue programs.
    Finally, it is ironic that many of the same groups which have stated strong concerns over the potential adverse impact of the Exchange's professional markets proposal on the liquidity and price discovery process of exchange-traded instruments are now arguing in favor of lifting the ban on agricultural trade options. The CFTC has also been very concerned over the potential impact on the price discovery process of the development of professional agricultural markets which would be allowed to trade on exchange in a similar regulatory environment as is being proposed for trade options. These seemingly inconsistent views on the effects of professional markets and agricultural trade options on the price discovery process are troubling and require further explanation.
STATEMENT OF HAROLD M. REED, GENERAL MANAGER, GRAIN DIVISION, THE ANDERSONS, INC.
    Good afternoon. I am Hal Reed, and I represent The Andersons, Inc. We are a significant regional participant in the Agricultural marketplace in Ohio, Michigan, Indiana, and Illinois. We operate grain elevators, retail fertilizer and Ag chemical facilities, and wholesale fertilizer facilities across those four states. We handle approximately 150 million bushels of grain, and 1 million tons of fertilizer products annually, and we deal with nearly 20,000 farmer customers each year. I currently hold the position of General Manager of the Grain Division.
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    For the record, The Andersons, Inc. strongly urges the subcommittee to support lifting the current ban on agricultural trade options. Our position, and the key issues which argue for the end of the trade option ban will be shared with you today, and will be more fully discussed in our written submission which I will leave with the subcommittee.
    We believe that there is a clear need and opportunity among agricultural producers, handlers, processors, feeders, and other participants that can be addressed by trade options. Eliminating the ban would be a positive step toward the development and evolution of more effective marketing tools for the purpose of risk management. The strength of this need and the significance of the potential benefits suggest that prompt action to lift the ban is warranted.
    I'd like to provide you with a few of the reasons The Andersons feel that the time is right for the ban to be lifted.
     Producers of ag commodities are in a new era of risk and opportunity due to changes in the US Farm Bill. The law provides significantly more flexibility and freedom to farmers in making marketing and managerial decisions. With the elimination of deficiency payments, this freedom brings a much more challenging environment for pricing and risk management. My farmer customers want, and need flexibility to meet this challenge head on.
    Additionally, we believe that changes in the global marketplace will bring a period of increasing price volatility. This suggests that there will be an increasing need for more responsive risk management instruments. Indeed, the CFTC's Department of Economic Analysis acknowledged in their recent white paper that agriculture... ''needs creative and flexible price risk management instruments''.
    My customers are much more diverse, high tech, and sophisticated than they were when I began work with The Andersons 18 years ago. Many farmers are now looking at alternatives to being ''price takers'' who simply accept cash market prices upon delivery of their ''generic'' grain to an elevator. No longer simply producing commodity products for commodity markets, many farmers are seeking to produce tailored products intended for specific purposes. It is vitally important that these producers have the opportunity to access similarly tailored and specific risk management tools.
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    As consolidation and sophistication continues in production agriculture, the customers of The Andersons are demanding increasingly sophisticated services. In just one township where we originate grain, 3 farm operations today manage acreage that was under the control of 112 individuals—just 10 years ago. Anyone want to guess whether the 3 that remain are sophisticated and demanding farm managers?
    Remaining participants are seeking every efficiency they can find. The very nature of agriculture suggests that there is additional cost efficiency and product differentiation available and necessary through the more open and competitive risk management environment that will exist with trade options. This is particularly so, now that the dominance of governmental acreage and price management is lessened.
    The non-agricultural marketplace has found valuable and competitive uses for trade options in many, many areas, as risks are shared more reasonably and more efficiently. Agricultural participants can find similar benefits through the introduction of products specifically designed for the uniqueness of agriculture. To the sophisticated user, trade options in agricultural commodities are little different from trade options on other commodities. We see no reason that our customers should be denied the advantages that are currently available to other commercial markets.
    The USDA seems to agree with me on the issue of need and opportunity available with the legalization of trade options. They've created the Risk Management Agency to focus on concepts and education that assist producers to manage risk in the changing marketplace. Some of the insurance concepts that I've heard from them include characteristics of trade options. In fact, it is my belief that the use of trade options in developing crop and revenue insurance instruments can and will reduce the cost of such programs for the government and the farmer.
    Some who are opposed to lifting the ban believe that such a move will result in an abandonment of exchange-traded contracts. I strongly disagree. The relationship between agricultural products and the futures markets is unique. Futures are an integral part of the pricing structure for these products, and that will only increase use of the regulated futures markets in the future. At the very least, commercials who offer trade options will likely utilize the regulated markets to hedge the risks of their trade option obligations. I agree with the Mississippi Farm Bureau, in their statement that trade options...may well enhance the use of regulated futures and options as risk transferring products.
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    Opponents further argue that lifting the ban will encourage fraud and misuse. These concerns exist in every market, regulated or not. From what I understand, the CFTC will retain its powers to act against fraudulent activities involving ag trade options under the anti-fraud provisions of the Commodity Exchange Act.
    We do have a few recommended conditions to lifting the ban.
    We believe that Ag Trade Options should only be allowed among the participants and activities involving those commodities in normal commercial activity.
    As a proxy for sophistication, we suggest that the rulemaking impose minimum net worth requirements of those offering trade options. This would serve to lessen the concern for any subsequent surveillance by the CFTC.
    We encourage the ban to be lifted under a pilot program. This approach would provide a safety valve mechanism should any of the concerns outlined in the May 1997 CFTC publication, be realized. We also believe that it should be made clear at the outset that the program is intended to be made permanent at the end of the pilot period.
    It is our encouragement that during the pilot phase, vendors should be required to submit a notice of their intent to offer trade options. In our opinion, this notice should not demand any specific descriptions of contract terms or features, nor should it carry any requirements for approval by the Commission.
    Finally, we believe that it is reasonable to require marketers of trade options to provide risk disclosure statements to participating customers. Such a statement might include the mechanism for dispute resolution the customer's acknowledgment that the trade option is no -speculative and is specifically intended for a business purpose; and that the customer understands, and accepts the financial risks.
    The Andersons, Inc. and I personally, appreciate the opportunity to offer our views today. We are convinced that lifting the ban on trade options will prove to be valuable for our farmers, our industry, and ancillary participants. We also believe that this will be strategically significant to the longer term viability and growth of Agriculture markets for the United States, and the U.S. futures markets. Our farmers need the opportunity to compete by securing revenue and managing financial risk, rather than continuing to chase prices.
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STATEMENT OF THE AMERICAN FARM BUREAU FEDERATION BY ANDREW WHISENHUNT, PRESIDENT, ARKANSAS FARM BUREAU FEDERATION
    The American Farm Bureau Federation (AFBF) appreciates the opportunity to provide comment and input with respect to the proposal by the Commodity Futures Trading Commission (CFTC) to lift the ban on trading of trade options on the enumerated agricultural commodities (ag trade options).
    We believe that the CFTC should propose rules to lift the prohibition on trade options on the enumerated agricultural options. However, we also believe that it may be appropriate to impose certain conditions and requirements on the writers (sellers) of such ag trade options, even though trade options on the non-enumerated commodities are exempted from all of the requirements applicable to off-exchange commodity options except for a rule prohibiting fraud (rule 32.8) and a rule prohibiting manipulation (rule 32.9). We believe that the unique characteristics and conditions of agricultural commodity production, pricing and trade make it appropriate for the Commission to provide a higher level of oversight and regulation to ag trade options than that which has been provided to other trade options.
    Benefits of Lifting the Ban on Ag Trade Options. AFBF believes that a number of benefits may result from lifting the prohibition on agricultural trade options. One benefit is likely to be an increase in the supply of, and competition in offering, option contracts. Currently, the only options available to producers are standardized, exchange-traded options. We believe that lifting the ban would enable and encourage the development of customized contracts and financing arrangements. Moreover, lifting the ban would permit a greater variety of option vendors, which could reduce hedging costs.
    Ag trade options may allow a producer to better manage his business risks. In addition, many hedgers may be more comfortable in relying on established cash markets for risk management. These traditional, established cash trading partners often have a greater understanding of the hedger's marketing position and risk management needs than others. These cash trading partners may, therefore, be better situated to recommend particular hedge strategies and contracts. In addition, ongoing business relationships with these parties may have allowed a greater level of trust to develop between the parties.
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    Ag trade options can be customized to the needs of producers. For example, futures commission merchants (FCMs) may offer trade options, to the extent permissible, that have features currently unavailable on any exchange, such as average-price options. Elevators and other first-handlers, on the other hand, presumably may offer option contracts having contract terms, product specifications or financing arrangements more closely tailored to the hedging or other needs of the customer.
    Many commercial feedlots, for example, offer ranchers and other cattle feeders complete management services including procurement of feeder cattle, feed purchasing and cash cattle marketing. Some also offer hedging services, but the cattle feeding customer must open up his own brokerage account and meet necessary margin requirements. If ag trade options were allowed, the commercial feedlot could offer complete management services including marketing and pricing management as part of their service package. Cattle feeding customers could deal directly with the feedlot rather than having to deal with multiple entities. Feedlots may also use ag trade options to offer tailored marketing services such as price windows, shared-risk contracts, or other more sophisticated marketing contracts.
    Trade options allow a hedger to specify expiration or delivery dates to coincide more closely with harvest dates, processing schedules or the timing of forward contracts. This reduces a hedger's exposure to the risk from mismatching the expiration date of an exchange-traded contract. Basis risk also can be reduced for the hedger by allowing a closer match to the grade of crop or livestock at a particular delivery location. In addition to tailoring contracts to match more closely the underlying commodity, customers, through the bundling of various options, can also gain access to contracts which hedge multiple risks.
    For example, instead of a custom cattle feeder having to execute separate hedges for corn and fed cattle, a commercial feedlot may develop an ag trade option which allows a rancher who retains ownership of his cattle to lock in a feeding margin. Both may gain from the transaction. The rancher gains a degree of certainty in his marketing program. The commercial feedlot operator is in a better position to market his services and may be able to take advantage of his expertise in feed purchasing and cattle marketing.
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    In many respects, the way the current ban on ag trade options is administered disadvantages the very producers it purports to protect. There are glaring inconsistencies which clearly work against producers. For example, in the cash grain trade, a grain-offer contract between two grain merchandisers is legal; but if a producer is paid for that call-away right, it is illegal. Commercial trading of barges and cargoes of grain is legal; but producer buy-back of delivery contracts is considered unacceptable. Buy-sell agreements among commercials are common and legal; the same activity by producers is prohibited. It appears that under the current regulatory system, legality is based on who is doing the trading or contracting or why it is being done. Unfortunately, producers are, for the most part, prohibited from using the same risk management tools that are available to others further up the marketing stream. Trade practice already allows the use of trade options beyond the producer The Burlington Northern railroad*s COT - Certificate of Transportation -- program is a basic trade option. Shippers pay a premium for the right to secure rail freight at a fixed point in time. There are penalties if the railroad can*t deliver; and if the shipper doesn*t want the cars, he or she must forfeit the premium (or sell the right to others). This type of trade option already is in use by the agricultural product handlers. It works well, allowing firms to better manage freight risk.. Furthermore, agriculture is the only industry where producers have been singled out as being in need of government protection.
    It should be acknowledged that ag trade options would trade in a less-regulated environment than exchange-traded options. It is inappropriate to automatically associate trade options with increased complexity. In some regards, it is the ban on trade options which prevents simple risk management tools from being developed. Some possible new contracts which are likely to be developed if the ban on ag trade options is lifted are: Higher-of contracts, Walk-away contracts, various forms of minimum price contracts, average price options, and look-back options. Many of the problems which arose with the HTA—Hedge To Arrive—contracts would not have occurred if walk-away contracts had been available.
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    Risks and Appropriate Regulatory Actions. There are several potential risks which may be cause for heightened concern if the prohibition on agricultural trade options were lifted. These include fraud, credit risk, liquidity risk, operational risk, systemic risk and legal risk. However, many of the these risks also exist for exchange-traded options. Much of this risk has been reduced through self-policing by the exchanges and through the surveillance activities of the CFTC.
    Decentralized trading would preclude the establishment of active surveillance and would put much more of the burden of market performance on the trading counterparties. Customization of contracts does increase the possibility of fraud and will make the oversight and policing of trade practices more difficult. However, we believe that the probability of fraudulent activities is not significantly different than that which currently exists in cash and futures markets, especially if ag trade options writers were required to be registered with the CFTC or an appropriate trade association.
    We do have concerns that producers may find it more difficult to detect possible fraudulent conduct by their counterparty. To the extent that there is a lack of daily marking of positions to market or reporting of account position statements, as a matter of practice or regulatory requirement, it may make it more difficult for a counterparty to uncover possible fraudulent activity. This may be sufficient cause for the CFTC to establish regulatory requirements for periodic reporting of account positions by option writers.
    We believe that it may be appropriate for the Commission to establish minimum financial standards for writers of ag trade options to guard against the risk that a counterparty will be unable to perform on an obligation. It may be appropriate, however, to establish less stringent financial requirements for writers of ag trade options who restrict their exposure to levels consistent with their cash market activities than would be required of those whose exposure exceeds such levels. In addition, it may be sufficient for the minimum financial requirement for ag trade option writers to be met by meeting minimum financial standards which already exist for the industry (e.g. State and Federal banking standards already set minimum financial and risk exposure standards. Likewise, federally licensed warehouses have minimum financial standards. A bank, grain elevator or insurance company that is an ag trade option writer and who meets these industry standards for capital reserves and risk exposure may be deemed to have met the minimum financial standards for writing ag trade options.)
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    We believe that producer will take steps to mitigate the potential increased risks of ag trade options. Based upon our observation of forward contracting and associated hedging practices, we anticipate that, although the terms of agricultural trade options will be individually negotiable, producers are most apt to enter into ag trade options that resemble closely the terms of exchange-traded options with respect to exercise dates, delivery grades and strike prices. To the extent that the terms are similar, it will be easier to monitor the financial condition of a position by observing prices on the exchange markets.
    It should also be noted that, in the case of agricultural trade options, the most likely counterparty to producers is the local country elevator, feedlot, or packer. Adding option contracts, particularly those with unusual terms, to the marketing mix of contracts already offered by an elevator, feedlot, or packer may increase the complexity of their overall position and make it more difficult to hedge. Thus, we expect the elevators, feedlots or packers to exercise caution in the development of ag trade options so that they can limit any increase in their operational risk related to the use of trade options.
    The CFTC has suggested several regulatory protections or conditions which could be fashioned to address the risks noted earlier. One of the regulatory actions proposed is a limitation on the size of transactions as a proxy for trader sophistication. The use of these proxy limitations, however, may make trade options unavailable to the smaller entities that might otherwise find them the most useful. We do not support the use of this means of regulation. Establishment of minimum size limits for ag trade options would eliminate much of their use to farmers, ranchers and livestock producers
    Another method of providing regulatory oversight is to limit those entities or individuals which may become trade option vendors. For example, it has been suggested that option vendors could be required to register in some capacity with the CFTC as a condition of doing business; or alternatively, the CFTC could consider creating new requirements that would be applicable only to the offer and sale of agricultural trade options. We believe that it is appropriate for the CFTC to establish registration requirements for option vendors. Such registration could be with the CFTC directly or through appropriate, certified industry associations.
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    We do not support the restriction of option vendors to commercial entities which are directly involved in the handling or use of the commodity. We believe that this would unduly restrict the development of risk management instruments. We believe that banks, insurance companies and other such institutions should be eligible to be vendors of ag trade options and developers of ag trade option based risk management instruments.
    We believe that the CFTC should provide regulatory guidance as the means of carrying out Section 32.4 which requires that trade options be offered only to a commercial entity ''solely for purposes related to its business as such.'' We would encourage the CFTC to delineate through general guidance those practices which in the context of agricultural trade options will ensure that the use of such options remains within the intent of the exemption. This format was used by the Commission in connection with HTA contracts when the CFTC was frequently asked for further specificity concerning the extent to which various forms of the contracts fell within the boundaries of the Commission's rules or policies or staff no-action positions. In response, the CFTC issued a Statement of Guidance on May 15, 1996. This statement provided specific guidance that could be applied to contracts or transactions to determine whether or not they were prudent, that is, could be used to reduce price risks. We believe that such a format, if applied to trade options, would prove valuable to the industry.
    We believe that it would be very appropriate for CFTC to require that a substantial risk disclosure statement be prominently displayed on ag trade option contracts which involve the writing of puts or calls or exposure to margin.
    We believe that educational activities regarding the trading of ag trade options are primarily the responsibility of private industry, producers, trade associations, producer groups and the Extension Service. We do not believe that the CFTC should establish an educational requirement for purchasers of ag trade options. However, we believe that it is appropriate for the CFTC to establish a proficiency requirement (Series III or equivalent) for vendors and/or writers of ag trade options. Anyone who directly offers or solicits ag trade options business with the public should be required to demonstrate the prescribed level of proficiency and market knowledge.
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    Summary. Agriculture is changing. Marketing of agricultural products is changing. Producers are subject to more risk as agriculture shifts away from government programs and relies more on free-market activities. Agricultural marketing policy must keep pace. Producers must have access to new risk management tools such as ag trade options. The CFTC should lift the ban on the trade options on the enumerated commodities, but with appropriate safeguards. These safeguards include registration of vendors, periodic position reporting requirements, establishment of minimum financial standards for vendors, proficiency exam requirements for vendors and/or writers of options and those that directly deal such contracts to the public. With such safeguards in place, the risks of fraud and abuses occurring in the trading of ag trade options will be kept to a minimum.
TESTIMONY OF NANCY DANIELSON, LEGISLATIVE REPRESENTATIVE, FOR THE
NATIONAL FARMERS UNION

    I am Nancy Danielson, and I am a lifelong member as well as legislative representative of the National Farmers Union. Thank you for the opportunity to present the views of the 300,000 families who belong to our organization.
    Currently, the Commodity Futures Trading Commission is in the process of reviewing the ban on non-exchange agricultural trade options, i.e., options offered to commericial businesses where the user enters into the transaction solely for purposes related to its business. The ban was enacted because of widespread fraud and abuse. Now some are calling for lifting the ban, to correspond to the trend toward deregulation in current farm policy. Proponents say non-exchange trade options provide producers with a necessary alternative for risk management.
    Policy passed by delegates to our 95th annual convention does not call for lifting the ban on agriculture trade options. However, National Farmers Union's policy on risk management and futures trading provides guidance on issues which must be considered in maintaining or lifting the ban. At a time when producers are experiencing a high degree of market volatility, it is essential we provide risk management alternatives which do not increase market risk. We believe the basic question before the committee is this:
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    Will lifting the ban on agriculture trade options provide one more opportunity for risk management, or merely one more opportunity for risk?
    Historically, commodities not enumerated in the Commodity Exchange Act could be traded in off-exchange transactions. This practice was subsequently regulated due to fraud and manipulation. What has changed today to indicate that fraud and manipulation would no longer be a problem for enumerated commodities?
    Potential Benefits of Lifting the Ban on Agriculture Trade Options. The benefits of lifting the ban are speculative, i.e., benefits may accrue to the extent traders offer additional flexibility in contract terms. Possible benefits include the following:
    1. Lifting the ban provides farmers with an additional tool for risk management. (2) Off-exhange traders may compete by offering options more tailored to the individual hedger's size and specific needs. (3) Unlike a futures contract, under an option contract, the hedger's risk is limited to the amount of the premium for the options contract.
    Some would add ''reducing the need for crop insurance'' to the list of potential benefits. However, we believe producers are unlikely to buy options instead of crop insurance, since producers have more experience with crop insurance and because crop insurance provides site-specific protection.
    Risks Created by Lifting the Agricultural Option Ban. We can only guess how much additional flexibility producers will have if off-exchange trade options are allowed on agricultural commodities. Ironically, it is this very flexibility that increases the risk of fraud and manipulation.
    (1) Nonstandard contracts are more difficult to regulate. (2) The lack of price transparency due to a decentralized market makes it difficult for participants to accurately judge the value of a contract.
    Therefore, if we decide to lift the ban on agricultural trade options, we should only do so on a trial basis with a pilot program. Results of the pilot program should be analyzed to determine whether the pilot program should be expanded. In addition, certain precautions are key:
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    Necessary Safeguards. (1) Trades must be subject to regulation by the Commodity Futures Trading Commission (CFTC) or the Securities Exchange Commission (SEC). (2) Congress must provide additional agency funding to allow adequate oversight.
(3) Vendors which trade off-exchange agricultural options must be periodically audited. (4) Disclosure of risk must accompany every contract and should be written in terms that can understood by the average person. (5) Vendors must be bonded at a sufficient level. (6) Education must be offered to producers and other potential contractors. Until producers have a full understanding of the product, they are unlikely to participate.
    Proponents of lifting the ban on agricultural trade options correctly point out that market conditions in 1997 make risk management more important than ever. However, it is unclear how other conditions have changed to somehow deal with the problems of fraud and abuse which prompted the ban on agricultural options.
    In addition, market conditions produce unexpected results. With the lessons learned from the hedge to arrive contracts still fresh in our minds, our members are not pushing the CFTC to lift the ban on off-exchange agricultural trade options and we urge caution in implementing any plan which moves in that direction.
TESTIMONY OF RICHARD ELLINGHUYSEN, DIRECTOR OF PROGRAM DEVELOPMENT, NATIONAL FARMERS ORGANIZATION
    The National Farmers Organization believes that market pricing alternatives, including off-exchange traded agricultural options, can be beneficial to production agriculture. However, NFO stands against the lifting of the ban on off-exchange traded ag. options, and must continue to do so until a clear understanding is reached as to how these products will be regulated, the integrity of the markets maintained, and the users of these products protected.
    To date not enough public focus has been given to the regulation of this activity. In light of problems surrounding the off-exchange product called Hedge to Arrive (HTA), used in marketing grain, it is clear to us that more consideration must be given to the regulation of such activity prior to further agricultural market deregulation.
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    The lifting of this prohibition would allow parties besides the futures exchanges to offer price related option contracts for ag producers and buyers, which would be in competition with the existing exchanges.
    This market competition could allow new and improved pricing vehicles for all parties at fair prices. This could be a benefit to producers who may or may not be able to participate in existing commodity trade options, due to the nature of their commodity or contract size availability.
    The lifting of this prohibition without proper regulation could also allow parties of insufficient market sophistication or financial wherewithal, or those with intent to defraud, more opportunity and latitude to mismanage pricing vehicles to the detriment of producers and buyers. Lacking financial wherewithal, a party offering off- exchange options on ag. commodities could collapse at the point when the public needs them most. This collapse would result in failure to perform and significant losses to the public.
    We have just entered a new ag. pricing environment where NAFTA and GATT have assumed a leading role in creating new market dynamics. Markets tend to be much more volatile now, and we can expect that volatility to continue.
    The new farm bill, the Federal Agricultural Improvement and Reform Act (FAIR) removes the price safety net from production agriculture. The combination of increased price volatility and the elimination of the price safety net make it imperative that farmers have more access to and use of, price risk management vehicles.
    The result is the need for ag. trade options, whether on or off- exchange. It is therefore critical that if off-exchange trade options are allowed for agriculture, they be carefully evaluated so as to determine the impact of these new options on our industry. Arguments can be made that this is precisely the time that more market risk management alternatives should be provided. We agree.
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    However, we must also agree with those who say that this is not the time to attempt a deregulated market price mechanism experiment, and ''see what happens.'' Production agriculture does not currently enjoy the price stability or safety net to warrant such an experiment.
Bankers and lenders to agricultural producers share a degree of risk with their producer clientele, and need more assurance that these products will be safe, secure and will adequately protect the investment that the lender holds in the farming operation.
    Recent HTA grain activity has shaken the confidence of lenders in off-exchange futures styled products, and assurances must be given that new off-exchange products do in fact reduce risk for the producer, and does not increase it. Therefore, it is NFO's position that off-exchange traded agriculture options be prohibited unless clear regulation of this potential new market is determined.
    That regulation must have at it's core several key factors: A regulatory agency, be that CFTC or SEC, must be assigned the task of regulating this new market. Financial requirements must be established under which it can be reasonably determined that those parties offering such products be financially solid enough to withstand substantial changes in market conditions.
    A balance sheet ratio should be determined and a maximum level of risk established for the offering entities. The entities should not be allowed to exceed a certain offering level based upon their financial wherewithal. The regulatory agency must evaluate and approve the financial condition at the onset, and in subsequent regular audits.
    Disclosure of the risks inherent in using these trade options should be required of those entities offering such products. The disclosure should be technically precise as well as provided in ''layman's'' terms, so that clear understanding by the user is achieved. The regulatory-agency should approve of such documents before trade cancommence.
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    Record keeping requirements must be established for the entities providing off-exchange traded products. This record keeping must conform to appropriate standards allowing for a complete audit trail. The regulatory agency will perform spot audits of all entities offering off-exchange traded options or related products.
    In summary, NFO believes that market pricing alternatives, including off-exchange traded agricultural options, can benefit production agriculture. But, NFO stands against the lifting of the ban on off- exchange traded ag. options, and must continue to do so until a clear understanding is reached as to how these products will be regulated, the integrity of our markets be maintained, and the users of these products protected.
    To date a lot of trade emphasis has been placed on the benefits of off-exchange traded ag. options. However, in the cold, hard light of the off-exchange product called ''Hedge to Arrive'' and the problems surrounding it, it is clear to us that an appropriate regulatory structure must be maintained with any initiation of additional agricultural market deregulation.
TESTIMONY OF THE NATIONAL INTRODUCING BROKERS ASSOCIATION
    Thank you for inviting me to share the thoughts and opinions of the National Introducing Brokers Association. I am Paul Georgy, President of Allendale, Inc., a brokerage and research firm located in McHenry, Illinois. Allendale , Inc., is registered as an Introducing Broker and a Commodity Trading Advisor with the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC). I currently serve on the Business Conduct Committee at NFA and am appearing here today as President of the National Introducing Brokers Association (NIBA).
    The NIBA is a professional organization of futures brokers. Our membership includes introducing brokers whose primary business focuses on price risk management programs for the farming industry. Many of our members offer crop insurance , or buy and sell cash grain as well as transacting futures and options business. All of our members are required to pass a national examination, be licenced, periodically undergo ethics training, be registered with the CFTC and the NFA and are subject to frequent audits by regulators.
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    The National Introducing Brokers Association is opposed to lifting the current ban on agricultural trade options. The NIBA voiced its opposition to off-exchange traded options as early as December 1994 when we identified these transactions as one of our top concerns to then CFTC Chairperson Mary Shapiro . We re-enforced our opposition at the Round table discussion called by the CFTC in December of 1994 and again at a Congressional hearing which you called in July of 1996. Most recently we testified before the CFTC at the public hearing held in Bloomington, IL regarding the proposed lifting of the ban.
    In preparing this statement, we referred to the CFTC's guidelines recently published in the Federal Register, information obtained from the Federal Reserve, CO-Bank, Farm Credit System, Farm Credit Council, ERS, USDA staff and Rural Business Cooperative Development with regard to the effect that hedge-to-arrive contracts have had on producers and elevators and to individual members of our association. Our membership voices its opposition to lifting the current ban on agricultural trade options and cites the following reasons:
    1. Increasing the number and type of flexible contracts available to producers, in reality may result in decreased flexibility of marketing because they are so localized. As elevators personalize each contract, the demand for the exchange option will deteriorate causing severely reduced liquidity. There will be an overwhelming supply of unique contracts, but the intrinsic value will be greatly diminished. Therefore, the very characteristics which proponents for lifting the ban cite as advantages to ag-options, are distinctly disadvantages. Price discovery will be inhibited, placing the producer at a disadvantage. As grain companies lock in farmer's grain through the use of trade options, grain companies will not have to bid a price in order to get deferred grain supplies. As an example, as elevators take a supply of grain into their possession, they allow the farmer X months until it needs to be priced. As more suppliers (producers) take advantage of these contracts, the end user has all his needs met for the next 3-6 months. When the farmer wishes to sell the end user has plenty of trade option inventory, therefore the end user has no need for grain that needs to be priced, resulting in a widening of basis and a lack of enthusiastic demand. The producer will receive a discounted price. This environment will create a new demand curve based on contract creativity and a supply curve that is based on the hope for future improvement in price.
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    2. Increased cost of protection for the producer. Proponents tout lifting the ban will reduce cost of providing the producer with a contract that will offer protection. However, the CFTC as well as other economic groups, contend that the potential liquidity risk could actually result in a higher cost product to the producer. Based on the above mentioned example, the producer is certainly at a disadvantage and the end result is a higher cost to the producer due to the limited liquidity. What about increased commission costs? It is our experience that when off-exchange contracts were recently offered through elevators, our clients entered flexible arrangements that now have producers locked in a long-term lawsuit over losses, a much higher cost of protection and drain on cash flow than farmers should have to pay.
    3. Decreased or no margin requirement will likely result in less regulatory protection for the producer. No margin requirement is certainly a great advantage for the producer. But, if these accounts were legalized, why wouldn't most customers close their regulated accounts? In fact, you could speculate that hundreds of IB's and CTA's, might drop their registration. Why not? No audits, no financial requirements, no regulatory requirements! Unfortunately, unregulated trading and lack of margin requirements helped contribute to the grave losses and social stress experienced in many communities this year. According to a poll of agencies conducted by Allendale, Inc. cooperative elevators experienced a 42 percent increase in closures/ownership changes last year. The magnitude of losses in 1996 at the cooperative elevator was over $40 mil dollars, four times the amounts lost in 1995. This does not include the losses of CountryMark, a three state regional co-operative, or any privately held regional or local grain companies. Total unresolved trading losses as a result of HTA activity is estimated at over $800 million and is expected to surpass $2.0 billion by the time the litigation is completed. This represents approximately 4 percent of the total net farm income and is one of the most dramatic non-weather related losses to the sector.
    4. The independent elevator will be placed at a disadvantage. The most probable immediate results on the farmer/producer will be a concentrating of the grain business of which a few elevators will severely impact the competitiveness of local grain bids. While some farmers may benefit from these contracts in the short term, the results will be further constriction of this industry, which could result in an advancement of vertical integration, reduced independent production and a possible long term trend towards higher consumer prices. Small elevators will be forced out of business and entire communities will suffer.
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    The National Introducing Brokers Association remains opposed to lifting the current ban on agricultural trade options. As independent businesspeople, we are interested in any improvements in our industry which will result in increased price protection and flexibility and innovation in marketing for producers. We offer the following suggestions which we believe would help achieve these goals, while maintaining adequate risk disclosure and market integrity:
    1. Encourage regulated existing exchanges to develop and offer new contracts that allow the producer to buy an option which guarantees a profit/acre. This should not be too difficult to develop by simply using the contracts already available and wrapping them together into a package at the exchange. The liquidity and the regulatory procedures already exist. The same could be done in the livestock. In fact, we are aware that the exchanges are already formulating these new concepts that might meet the needs of the industry. The system is responding to the needs of the industry. So why change the system? Thus, the best compromise is no compromise, but rather to insist that all new contracts are traded on the exchange.
    2. Creating new requirements for those conducting trade options transactions. These new requirements should include registration, financial requirements, audit requirements, full risk disclosure and the authority of the CFTC to regulate the transactions.
    3. Seminars and educational meetings for vendors and farmers and producers.
    4. Pilot programs, if they are authorized, with hearings at the end of the period to evaluate the usefulness of the contracts.
    In summary, increasing the protection of the producers, improving price discovery and increasing the stability of our industry is extremely important to the National Introducing Brokers Association. Therefore we believe the current ban on agricultural trade options should remain in force. Thank you for giving me the opportunity to present the position and concerns of the NIBA. As this committee continues work on risk management issues, our organization stands ready to help in any way you see fit.
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